Interviewer: Hello. I’m delighted to welcome you to Fiducia’s latest webcast of December 2015. I’m delighted to be welcoming our friend Michael Hughes. He’s our chief economic adviser at Fiducia. It’s been quite a few weird months if I can use that expression. I suppose there are four topics that our clients and especially myself are quite interested in, being, in general, we’ve had a UK general election where the Tories have had their first conservative government since 1996, so 15, 16 years ago. The budget.
We’ve also then had the issue of Greece, we’ve had China, and finally, I think as of last week with Mark Cline talking about a rate rise with regards to banking and base rates. So there’s four big topics that our clients are quite keen to understand and we’re looking for your thoughts and guidance on what has happened and what might happen from then on. Can I ask you really to, I suppose, tackle the first one, which is the UK general election and the budget?
Michael: Well, the election from an investment point of view was something of a relief because it removed the policy of uncertainty that would have been around and we had a coalition government again. Because we know that the correction to the debts we have the UK was never going to be achieved in one parliament, it was always going to take two. And so it was always a question about how that was going to be achieved. Now it is pretty clear and we now know the road we’re going down for the next five years. So from that perspective, it’s no great surprise that the markets jumped with a degree of relief. It’s certainly appreciated, and by and large, it was deemed to be good news from an investment perspective.
Having said that, we are still living in a world where there are long term issues. And quite clearly, we’ve now had a six-year recovery starting in 2009. Even though it’s been fairly modest, it’s unusual for a recovery to take that length of time. On that basis, there is an expectation that, that recovery won’t gather momentum over the next year or two, even with boosts that we’ve had this year from the lower oil price. By and large, it loses its momentum. And one of the reasons it could lose its momentum is that interest rates start to rise. We have been forewarned of this. It’s pretty unlikely, even over three or four-year perspective that we will see interest rates back to the 5 and 6%s that we saw a few years ago. In fact I would have thought that the peak in interest rates is probably going to have a three in front of it. But either way, that’s a big move from the virtual 0 interest rate we’ve had in the last few years. That is one of the breaks that has been coming on. It’s coming on because inflation, which has been almost ignored in the last few years, actually will be much more evident in the next year than its been for a while.
And the reasons for that are largely to do with the economic cycle. If you have six years of recovery, and unemployment goes down, you start seeing wages go up. Wages are the biggest component of inflation. So if we start to see higher wage settlements, and this isn’t just in the UK, you’re seeing it in Germany, you’re seeing it in the United States, you see a little bit of it in Japan. So it’s a different environment from before. You shouldn’t be so surprised if you start to see interest rates go up. Not just in the UK but in the US and possibly even in some places else where in the world.
Host: It’s interesting I think because base rates were down to 0.5% in March 2009. I was quite blase about it. They’ve got use of sustaining patterns and a lower interest rate, and of course as you’ve said inflation has gotten down to an extremely low rate. Moving forward, I think at the beginning of this year Carney [SP] indicated that it’s going to be rising. Do you think that had much impact on perhaps the spending power of people or do you think that that’s going to count as normal?
Michael: Because wages are gathering momentum and are rising faster than inflation is likely to rise, then obviously real wages will increase. But having said that, there are some areas of the economy, the service sectors particularly, where you will see a much higher level of inflation than growth in wages. And if you think back to the budget, the increase in the tax on insurance premiums will also go through to the inflation calculations. There will be a slowdown in the rate of growth of real wages, but we’re still living in a period of austerity to correct the build-up of debt in the last 20 years. And on that basis, that’s not so surprising. So it’s the best of all considerations, even though it may not be as great as we’ve seen in the last few months.
Host: You mentioned about wage inflation and austerity. Of course, that’s something that we reflect back into Greece, to that topic. Now, of course, they’ve got issues, they’ve cut pensions and bits and pieces like that, but, of course, Greece themselves, the austerity measures has caused all manner of front page headlines over the past year. Especially over the past few weeks. Where the [inaudible 00:05:37] gone they’ve come back, they’ve gone, they’ve come back again. Tell us what your view is on that.
Michael: Well Greece has paid a very high price for staying in the Euro. They obviously want to be a member of the Euro, but the price they’ve had to pay to do that is quite extreme. Whether they can survive having paid that price is somewhat debatable. But I think that the whole episode of Greece and the way it’s been handled has reflected rather poorly on the vision of a unified Europe. Because not only do you have splits between countries, you have splits within countries. As we will see in the Spanish and the Portuguese elections later this year, there may be a bit of a backlash against austerity there as well. So Europe isn’t the place that it was a few years ago. The vision has been dented somewhat. And partly because of that, I think the Euro, which has been falling within the last three or four years, I think will continue to fall reflecting in fact that Europe isn’t the perfect place that people had hoped for.
Host: You mentioned Spain and Portugal. Is there a fear there could be a contagion and if something happened to Greece everybody else would follow?
Michael: Well, to some degree it has had happened to Greece. And people are now saying, “Actually, austerity is too extreme.” Arguably the position of Spain and Portugal is far healthier than that of Greece. So to some degree, they can and have withstood the pain better. But it’s the politics here that’s the issue, not economics.
The political backlash against the sort of vision for Europe that was seen a while ago has been dented. When you add to that the unrest in Turkey, the effects of Ukraine and Russia, then the idea that the euro zone can grow in terms of numbers of countries in the way it has in the last few years, is now being questioned. And you have the Prime Minister of Sweden saying, although Sweden and Poland were thinking of joining the Euro, now that’s probably years if not decades away.
Host: Do you see a situation where the sovereign European states differ markedly in their approach to economics to the northern European states in that as you mentioned, the Swedes and the Polish who say “Hold on a minute. We see what’s happened in Greece, we’re not too sure now.”
Michael: Well, there is a divide, clearly between the north and the south. The south tends to have the debts, the north tends to have the savings. That isn’t going to change very quickly. But there are huge imbalances within Europe. The biggest one interestingly is the size of the surplus in Germany. Germany now has a count to count surplus equivalent to 8% of the size of its economy which is unprecedented. And Germany needs to rev up its engine in order to share some of that or transfer some of that wealth elsewhere. That is why you are starting to get labor unrest in Germany. You’ve had 350,000 lost days through strikes this year so far. Last year, you only have 150,000. So you are seeing labor problems in Germany which will be answered by higher wages in Germany. So you will start to see inflation pick up there, even if the sovereign states continue to have a more deflationary term. So the split between north and south will get wider.
Host: You mentioned that the powerhouse of Europe being Germany, of course, which has seen the powerhouse of perhaps Asia, more recently being China. Now that I think perhaps because of Greece is so close to home, has not had as much attraction as [inaudible 00:09:22]. But when you look at China, if my figures are correct, in June, the Shanghai index was 5166. And then it started the 2nd week going down to 3 1/2. Its come back up since then. What is going on in China?
Michael: Well China has had something of a stock market bubble. So to have a 30% correction quite quickly isn’t perhaps so surprising when you have had that degree of unsustainable rises and checks. Clearly the Chinese are concerned to ensure a degree of stability, not in terms of sending the market back up, but ensuring that you don’t have a complete collapse. Because if they did, confidence would go, and people who had been speculating in the local stock market would flee and there would be a real problem for that.
So they have cut interest rates, they have tried to introduce measures to stabilize the situation, but it has been a roller coaster ride. Remember, the financial markets in China have not developed as quickly as the economy has. And that’s part of the issue. They have to reform their capital market. They have to make their currency more freely used. They’ve taken measures to do that. And it is interesting to look at the long-term empire-building that China is doing, with the end of the empire that the euro zone had been pursuing. One has been dented, the other, I think, continues to roll out.
Host: I think China has enough power to change its course. Do you think they are doing enough, or do you think that there is more for them to come?
Michael: Well from an investment perspective, the thing that I think we have to bear in mind, and we’ve talked about it on previous interviews, is that if you’re looking at how you get out of this debt mess, you have to look at companies, because they are going to be the ones that are the engines for growth. Governments can’t be, and consumers can’t, because they have lots of debt.
And if you look at 10 years to the likely 500 of the biggest companies in the world, nearly half of them will come from the emerging economies. Some you may not yet have heard of. You are beginning to see, a lot of them are Chinese, but not all. And they are starting quotes on western stock markets and as hence you become more familiar with them. And people will be looking to invest in these companies not because of the Chinese story necessarily, but because these are new global companies that are able to compete with some of the older western companies that frankly, would find life much more difficult.
So from the investment perspective, one of the themes that we’ve been pursuing is looking at those funds that can identify the new winners, the new corporate winners, over the next 10 years. And that is a very strong investment message which we’re trying to incorporate into Fiducia portfolios.
Host: In fact it’s quite an exciting time from an asset location point of view, trying to identify, is it the Eddie Barbers of the world, the guy who eight months ago, on the New York Stock Exchange. So a lot of analysis going into that. So that’s very much…I suppose that’s very much the start we’re looking for is again, looking forward and trying to identify, the asset classes and perhaps regions that will be powering the portfolios ahead.
Michael: That’s right. There are two big themes in the portfolios. One is to look at the success stories of the future, and many of them are coming from the emerging world, not the least China. And second is to make sure that the asset classes that we have covered in our portfolios are appropriate for the next 10 years. If you go back the last 10 years, or indeed the last 20 years, there hasn’t been a major differentiation between the returns you’ve got from bonds, from equities, from property, from so-called alternative asset classes. Part of it has also been because of the distortions that quantitative easing brought. But part of it has also been that you had convergence of policies. Everybody was fighting inflation. They’re all going the same way, and hence, the results have been very similar.
Looking forward, making sure that you don’t have the same asset classes that you’ve had in the past, is a key consideration. And if you look at the Fiducia portfolios related to many others that we look at outside, you will see that we have far fewer bonds, but we have much more in what we call the “alternative asset classes”. Things like property, private equity, infrastructure, hedge funds, where they’re well-managed. These are the ways that we’re able to compensate for the impact that the bond markets going into retreat may have. And this year is now looking the first year for a while where the returns from bonds for this year will be negative.
Host: Fascinating. Well, that’s it. Thank you, Michael, for his insights into whats happened over the past few months and of course with Greece, China, and the base rate general elections. I thank you very much for that. We look forward to welcoming you to the next webcast which is due at the end of this year. Thank you.