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John-Paul Smith, head of strategy at Pictet Asset Management, has had a long track record in making timely calls in markets. He was one of the first to warn of an impending Russian debt crisis in 1998 and he built a strong reputation as one of the leading analysts in emerging markets.
Now Mr Smith advises FT readers to to shut their ears to “the cacophony of bearish comment and the negative ’newsflow’, and think longer term”.
But are we through the worst of the fear surrounding subprime? Is the long term prognosis for the US economy actually very good? And are we likely to see a rising dollar and a sharp rally in financials as Mr Smith predicts?
Mr Smith answers your questions on the outlook for global markets and whether the US is the best long term bet.
When do you think the US markets will recover and start to go up again?
John-Paul Smith: My bull case for the market is medium to long term based primarily on the low valuation of the dollar and US equities. I’d also like to stress that while I believe the absolute performance of US will be very good, my argument is more that US equities will outperform their counterparts in Europe and emerging markets, as well as commodities, again on a longer term basis.
I’m more wary of making a short term prediction because the cheap economically sensitive sectors such as financials and consumer discretionary may well get even cheaper as the newsflow from the economy worsens. Nevertheless if I had to say one way or the other, I would suggest that the credit situation, which has led the equity market downwards, may improve from being catastrophic to merely dreadful, which should be enough to provide the markets with some relief.
I’m also assuming that the equity market is discounting a peak to trough fall in house prices of some 15-20 per cent. If you disagree with this assumption or think that house prices will fall further then you should probably remain wary for now.
Should a US based investor begin to look to the US dollar as a buy low good investment for the future?
Steve, Charlotte, NC
John-Paul Smith: Most US investors seem intent on increasing their international exposure, which has been the rational strategy for the past six years. The problem with retail and to an extent institutional investors is that they tend to allocate looking in the rear view mirror ie buying the winners over the last one, three or five year periods.
I would suggest that at this point, most US investors should begin to consider investing in their own market again based on the twin premises that US stocks are cheap and that investing abroad, especially in Europe might generate losses on the currency exposure.
You have stated that the US housing market will continue to deteriorate; is this an opportune moment to invest in US homebuilders, or is it too early?
Michael Barr, Bedminster, NJ
John-Paul Smith: The homebuilding stocks have been huge underperformers over the past two years and there is no sign of any upturn in the sector yet. Nevertheless just as these stocks moved down well in advance of the housing market so they should begin to recover well in advance of any stabilisation, so I think I would buy the homebuilders, preferably on the inevitable weak days in the market as these stocks are incredibly volatile.
You may well make the most money in the more leveraged plays but there is also a real prospect of bankruptcies in the sector, so a more prudent(!) strategy might be to buy a basket of these stocks or focus on the better capitalised ones with the lower operational and balance sheet gearing.
Do you think that the Fed may make the situation worse by propping up an already shaky secondary lender universe. Wouldn’t it be better in the long term to simply let the market determine the winners and losers in the subprime mess? And won’t it do so sooner or later anyway?
Kent Taucer, Oregon, US
John-Paul Smith: I have some sympathy with the “Austrian” argument of minimum state intervention and creative destruction but it’s totally impracticable in the current situation. Any system can see runs on financial institutions, which is in a sense what this credit crisis boils down to and at some point the central bank has to step in as the lender of last resort.
This has just happened in a very obvious way in the UK with Northern Rock and even the supposed hard line ECB have been pumping money into the markets. The Feed simply cannot allow the whole credit system to jam up completely without risking a 1930’s scenario in the US, which would then spread globally.
Over the next few months, market forces should take over and buyers emerge for at least some of the debt tranches at realistic prices. One thing which does bother me more than Fed intervention is over-zealous regulation, which could force banks to mark their assets to market using highly illiquid and unreliable financial instruments as benchmarks. If this had happened during the 1980s Latin American banking crisis, then some of the largest banks in the US, would have been technically bankrupt.
What as shareholders we don’t want to see, is the banks forced to unload debt at highly distressed prices to predator funds who will then make a lot of money away from the quoted sector. We need more holistic rather than overly prescriptive legislation, which reflects the overall context of the market rather than merely laying down narrow criteria in a belated attempt to shut the proverbial stable door.
What is your definition of the long-term and what sectors do you think best positioned? If financials are to rally, is this a function of investment by sovereign funds? Or are they merely a variable that impacts on the timing of the rally? And what are the end-points for the commencement of such a rally?
Adam Toft, London
John-Paul Smith: The long term to me is three to five years and up until this year, I’ve found that when one invests with that sort of time horizon, the short term sort of falls into place.
This year has of course been the worst year for value, or at least anti-momentum investors, since the tech bubble of 1999, and I have been no exception to this. My whole long term view is predicated on commodities having formed almost as big a bubble as tech was in 1999, although I have no way of knowing when this bubble will begin to deflate.
For me, the best sectors are the cheapest and most unloved. I’d say US financials are extremely cheap at present, provided you share my belief in the ability of that economy to clear over the next year. The other sectors I like are those with a high intellectual property content, namely tech and healthcare as there are plenty of cheap stocks and conceptually, investors are more interested in tangible assets such as commodities in sharp contrast to 1999-2000, when they only wanted to buy intellectual property.
As far as the sovereign funds are concerned, its good to have long term rational investors with deep pockets about, but in general if the assets are cheap enough, then the investors will come.
Can you explain your prediction of a rising dollar? With interest rates looking to go down even further (it seems that Mr Bernanke likes to deal with the excesses of an overly loose monetary policy by printing more money) what is the appeal of holding US dollar assets?
Clement Loh, Toronto
John-Paul Smith: The dollar and the yen are very cheap against the European currencies. I prefer the dollar because the US should have a higher trend rate of growth given superior demographics, a more flexible supply side and in my opinion anyway, better productivity potential.
The interest rate differential with the euro is likely to evaporate for a time but this hasn’t worked in favour of the US for the last two years, so it may not matter too much the other way round.
I can see your point about an excessively loose monetary policy but I’m not sure I agree, given the apparent lack of inflationary pressures outside commodity prices. Moreover, you could argue that ECB has actually responded to the current crisis with an even easier monetary policy in terms of the money pumped into the markets. .....................................................................................................................
Since the markets seem to be driven at least as much by perception of events as by fundamentals, do you expect some sort of watershed event or turning point that will re-ignite positive momentum in the markets, or will it be a buildup of fundamentals that overcomes the current pessimism / predictions of recession? What do you think this change point will likely be?
Larry Lindquist, Boston, US
John-Paul Smith: This is a very difficult question to answer. The most likely catalyst is an amelioration of conditions in the credit market. This would be most likely a gradual process with a combination of price discovery and bargain hunting from distressed debt or vulture funds. You could however just about construct a scenario where the whole hedging process unwinds in a fairly short time horizon as short positions, many of them speculative, rather than for hedging purposes, are unwound very quickly indeed.
Needless to say, banks would be massive outperformers in this scenario, with the exception of any who were unable to unwind their short positions quickly enough!
As I am UK citizen investing mainly in emerging market funds whose dealing currency is in USD it will be beneficial if the USD gains against the GBP. Do you see that happening in the next three to six months, and if so why? Also which emerging markets do you recommend investing in? Both China and India seem to be overheated.
John-Paul Smith: I’ll stick my neck out here and make a shorter term forecast (remember my track record of short term calls is decidedly mixed), namely that sterling will be the weakest of any of the major currencies. This works in a weak or strong environment for the global, US led, economy.
If I’m wrong about the US and it goes into recession, then financial markets will be weak and the UK as a very open economy, highly dependent on the City of London, will suffer disproportionately. If the US is stronger than anticipated, then the dollar should strengthen.
The UK property market will also be very vulnerable in weak US scenario. Although the physical property market has yet to weaken much, property and related shares have performed almost as badly as their US counterparts, which tells you that there is a big potential problem here and the valuations of residential properties relative to earnings were far higher than in the US even before the falls in house prices here.
How would you rate Indian/Chinese stocks vis-a-vis US equities as a long term prospect? Do you think that the US dollar increase would benefit US equities more than emerging market equities given the dependence on US for many Chinese and Indian firms, especially tech firms?
Sandeep Manhas, London
John-Paul Smith: The problem I have with Indian stocks is simply one of price and valuation. Although earnings are growing strongly, a prospective PER of around 20x, is simply too expensive for me, especially when there is some evidence that the economy is overheating.
Having said that there are some truly world class companies and corporate governance compares very well with other global markets. Ironically, some of the worst performing stocks this year, have been those with the highest intellectual property content such as the IT services, which I think are much better placed for the long term than the purer domestic plays.
China is different. The valuation is similar but the market is in my view, more exposed to cyclical sectors and there is still a lack of transparency, less with the company management and more around the relationship between many of the companies and the state. The Chinese economy is also showing clear signs of overheating but then
I’ve been saying that for at least two years and there’s no sign of a slowdown for the time being. The Dollar issue is a complex one but I would say that the vast bulk of the Dollar gain I anticipate, will be at the expense of the European currencies rather than the Asian ones.
Since your group is actively investing into Ukrainian shares, I would like to ask your opinion regarding impact that situation in US and European capital markets might have on Ukraine within next six to 12 months. So far, the market has not seen much of an impact, but there are worries that investors might start pulling out their investments from emerging markets like Ukraine taking into account overall sentiment that currently prevails on the developed markets. Shall we expect to experience something that happened in Russia back in 1998?
Victoria, Kiev, Ukraine
John-Paul Smith: We still like the Ukraine in the context of emerging Europe, Victoria, along with Turkey and the Middle East. Unlike Kazakhstan, Ukraine has not had any significant funding issues in its banking sector, which could trigger a systemic crisis and the bulk of stocks listed there are still pretty cheap.
The main risk to Ukrainian stocks in our view would be a significant slowdown in neighbouring Russia, which doesn’t seem terribly likely unless or until we see a major fall in the oil price. Domestic politics are always noisy but fiscal policy, which is the real gauge of good government, has been fairly reasonable through 2007.
About the expert
After joining PAM in 2001 as head of emerging markets, Mr Smith took on his current role at the start of 2006. PAM manages some $100bn of assets. Mr Smith describes himself as a value-based investor with a strong contrarian streak.