Is Britain really turning Japanese?

Debt markets tell us more about the world than equity markets, and M&G’s Mike Riddell says they reveal a grim picture. Are America, Britain and Europe going the way of Japan, he wonders.

Never again say that bond managers are dull. M&G’s team of “bond vigilantes” has revolutionised fixed interest investing: they’ve made it interesting.

The reason? Debt markets tell you more about the world than equity markets. Take, for example, the autonomous region of Galicia in north-western Spain. It won’t ever feature in a report on equities. But might it be the spark that lights the next crisis in the eurozone?

Galicia is asking Madrid if it can suspend payments on its debt. In other words, the regional government is close to bankruptcy. Over in Catalonia, the Generalitat (regional government) is facing an ever more desperate struggle to refinance its huge borrowings. It has effectively been blocked out of public bond markets since March, and the yield it is paying over national government debt has almost tripled this year.

“The most over-valued currency is the euro. In the world government bond index, 30% is in euros. I have 1%”

M&G’s Mike Riddell, who guides me towards the finan­cing issues of Spain’s autonomous regions, is not suggesting the problems are insuperable. After all, New York went bankrupt in the 1970s and America didn’t collapse. But as the manager of the M&G International Sovereign Bond fund, he sees it as one part of a global debt jigsaw in which the picture that is emerging is grim. Indeed, it’s very grim, if you’re American, British, Irish or Mediterranean.

The word that Riddell keeps coming back to is “deleveraging.” His basic premise is that core inflation in America and Europe is low and falling, even if in Britain it’s (temporarily) above trend. Monthly headline American consumer price index (CPI) inflation has fallen for three consecutive months, which has only happened a few times since the data series began in 1947. Eurozone CPI is 1.4% – and that’s before the coming austerity measures. So forget about rising interest rates, it’s not going to happen. Riddell says it may be years before the Bank of England raises rates in Britain.

Does this sound like Japan over the past two decades? Precisely. Riddell issued a note last week headed: “Turning Japanese, I Think We’re Turning Japanese, I Really Think So”.

“There is only one explanation for why two-year US Treasury yields broke below 0.5% on Friday August 6 (an all-time low), or why 10-year government bond yields in Germany and America are 2.5% and 2.9% respectively,” he says. “The bond markets clearly think there is a very real and increasing risk that the developed countries are going to end up looking like Japan.” (article continues below)

Hold on. Last week we saw bumper growth figures coming out of Germany, and better than expected figures from France. Doesn’t this suggest that the recovery is strengthening?

Riddell says we shouldn’t be fooled. Japan recorded a similar spurt in growth in the years after its bubble burst. “The problem was that what appeared to be reasonable growth was a result of a huge surge in government spending and monetary stimulus. It wasn’t sustainable. A lack of consumer demand, a broken banking system and falling asset prices then combined to feed into falling inflation.”

Riddell says the British banking system remains broken. Look, he says, at the Barclays results, which reveal how much it is dependent on Barclays Capital for profits, not its underlying personal and commercial business. He also argues that house prices in Britain remain seriously over-valued. And as consumers repay accumulated debt, don’t expect the high street to come to the rescue.

But there is an upside to Riddell’s relentless gloominess. The opportunities to make money in sovereign debt may never be better. Over the past three years his fund is up 63%, which knocks the socks off the idea that investing in gilts and government bonds is a low-risk, low-return business.

The place to hide, he says, is US Treasuries and German bunds. “The areas where I am most confident that it’s going to turn out like Japan are the US and the EU. So I have a large exposure to medium and long-dated US government bonds and long-dated German government bonds … in the flight to quality, US Treasuries are the ultimate haven.”

The other side of the coin, so to speak, is currency. As an international bond manager, currency is where you make most of your money. And while Riddell loves German bunds, he hates the euro.

“I think the world’s most over-valued currency is the euro,” says Riddell. “In the world government bond index, about 30% is in euros. I have 1%.” He points to a report suggesting that Ireland’s government deficit might hit 30% before long as it continues to grapple with its banking zombies. But he doesn’t expect the euro to combust (despite potentially enormous problems in Ireland and Spain) as there is too much political will behind saving it, he says.

He is overweight the dollar and emerging market currencies, preferring the Malaysian ringgit. Malaysia has one of the world’s strongest trade surpluses and its currency has been appreciating at a rate of 9-10% year-on-year. Riddell is not a fan of sterling, but neither is he a bear, broadly seeing the pound appreciating against the euro but not the dollar.

The major risk factor in his world view is that economic growth is stronger and deeper than he expects. If you see evidence of vibrant bank lending to individuals and corporates, it will suggest that growth is sustainable, interest rates will “normalise” and you won’t want to be in American or European sovereign debt.

I also wonder about mean reversion. Do you want to be in an asset class – bonds – that has done so well for so many years, rather than equities? If equity mean reverts, then surely it will be the asset class to be in. “If we mean revert, then equities are a fantastic investment. But if we are heading towards a Japan-like scenario, then although equities look, on the face of it, cheap, they could get a hell of a lot cheaper.”

After talking to Riddell, you leave with the impression that M&G is an intellectual powerhouse on debt and credit markets. But you also come away rather depressed. As he says: “Bond investors have a habit of seeing disaster. I’m probably one of the few people who is even gloomier than Jim Leaviss.”