Pensions are now a hot topic, and the recent deal that British Airways has come to with its unions provides an interesting data point. In order to preserve currently promised benefits, employee contributions have to rise to a level equivalent to taking a 5% pay cut. This does nothing to ameliorate the extent of the current deficit – it just helps to stop it getting bigger. This (material) hit to individual income is not going to be unique to employees of the World’s favourite airline. The front page of Barrons recently focused in gory detail on the deficits of the gold-plated pension regimes of the U.S. states, and the numbers are not only gargantuan; they do not appear in any future estimate of the States’ funding requirements. This is something of a blow as California, Illinois and several others appear to be functionally insolvent already. We therefore view Moody’s decision to UPGRADE the ratings on 70,000 instruments issued by US municipalities as continuing their dream run of forecasting over the last few decades, and find it genuinely impossible to understand why anyone takes these organisations seriously – yet their prognostications over the UK’s potential loss of its AAA status, or Greece’s ‘stable’ ratings still get headline treatment in the press. The reality is that playing pass the parcel with debts does nothing to reduce overall indebtedness and that the only way to fund our ageing Western population’s pension requirement is to save more and accept lower benefits. Neither will be welcomed by politicians or citizens but both are unavoidable.

For the majority of people employed in financial markets, the experience of our working lifetime (30 years or less) has been one of falling interest rates in the post-Volcker era. In that period long bond yields have gone from 15% to 3% and short rates have spent much of the past decade at levels near zero. Arithmetically it would be difficult to argue for much further downside in rates, but there does seem to be an implicit belief in markets that rates can remain low for a very long time. That is what Mr. Bernanke and Mr. King are saying, so why should we doubt them? Mainly because the markets will eventually do the job and the many distortions in the current interest rate complex will have to be unwound. An environment where the Fed and the Bank of England are the ONLY net buyers of sovereign issuance and where the Fed via Fannie and Freddie is virtually the sole provider of housing finance is clearly not sustainable. So what level could interest rates go to? A cursory glance at a 30 year chart would show that long rates doubling from current levels is entirely feasible over the next few years – that’s where they were in 1999 after all, and that is hardly ancient history. Yet a 7% nominal, 2% real rate with 5% CPI seems inconceivable to most market participants, and would wreak havoc with most valuation models. This may not happen in the near future, but history tells us that it is not that unlikely in a year or two. Beware extrapolation of recent history to justify current valuation levels.

An oft-cited statement from the bulls is that as credit spreads are back at pre-Lehman levels, so equity prices should have rebounded to similar levels and therefore there is an easy 10% upside to the S&P 500. Attractive as this simplistic logic may be, it fails to take account of the ‘departed’ of the financial sector. AIG, Fannie and Freddie, Citi, CIT, WaMu… the list goes on. These share prices are not getting back to 2007 levels under any circumstances – any they probably account in aggregate for around 10% of pre-Lehman market cap. We would therefore characterise the market as having fully recovered already, yet fail to see how one can be as bullish now as one might have been in those halcyon days when banks were safe and the financial bit of the news was a 15 second recap of where the indices finished that day.

Siemens have just abandoned their bid for a Saudi train project and gone into joint venture with the Chinese as the only way to compete. Huawei and ZTE continue to take market share wherever they bid (except in the US as they aren’t allowed) from Ericsson, Lucent et al. Abu Dhabi went with a Korean bid for their first nuclear power plants, much to the chagrin of the French. Employment in the UK in electrical and metallurgical assembly has fallen 60% in the last 8 years. The numbers of beauticians and psychologists are up 60% in the same period (source: UK government statistics). At least we will be looking good and psychologically attuned to our descent into economic irrelevance. The West is lazy, indebted and living in a fantasy world where these ‘services’ are meant to support what the UK survey laughingly describes as ‘the jobs of an affluent society’. If you want to make money, do not invest in countries where a 35 hour week and poor tertiary education is the norm. Go east… or at least keep your money there.

Many investment bankers have been touting 2010 as ‘the year of M&A’, and from an Asian perspective this self-serving epithet may turn out to have a kernel of truth. Prudential bidding for AIA, Astro All Asia and Corporate Express being privatised, Arrow Energy bid for by Shell and Petrochina, CNOOC buying a stake in Bridas….it all seems to be happening. Some of these deals make sense ‘strategically’, some even stack up numerically. Some are driven by different agendas (China and India buying resources), some merely reflections of deranged egomania on the part of executives. Irrespective of rationale, we want to be on the side of the target, not the acquirer, and can see a lot of possible deals out there, some of which we are already involved in. We never predicate an investment on the hope of a bid, but if it comes together with a stock that is fundamentally cheap, so much the better. On the other side of the coin, we actively do not want to invest in acquisitive companies given the history of value destruction for most on-market deals, so that does colour our view on some of the larger companies in the region, even if they look cheap.

It has become fashionable to decry the Chinese economy as a bubble, and many articles are currently doing the rounds, ranging from GMO’s sensibly argued piece to a rant from an ex LTCM alumnus who, while eminently qualified to spot a disaster in the making, clearly has a rather spotty track record of doing anything about it. We are far from perma-bullish on China, and can see all sorts of problems down the track, ranging from incipient protectionism in the West, insufficient arable land and water, over-investment in certain types of fixed assets and, ultimately, the need to adopt some form of universal suffrage. Yet the immediate concerns relate to over-extension of credit, which would be the harbinger of lots of bad stuff if it were not an explicit extension of the Government’s fiscal stimulus. Bankers in China are still more incentivised by central diktat than by some arbitrary measure of capital adequacy or non-performing loan, and overall indebtedness of China including all local government debt still compares favourably to the same measures in the West, which as noted above massively understate our longer dated pension liabilities. China may not be the economic miracle that some hope for, but it is unlikely to implode in the next year or two at least.

STOP PRESS:

Over the last couple of days, post writing the above, we have noticed a stream of news items pointing to an increasingly black picture over pension and benefit funding, with dramatic and negative implications for consumer spending, corporate profits and government deficits. Mitsubishi Heavy, still solvent unlike JAL, would like to pay its pensioners less. The Automobile Association (roadside assistance) in the UK is about to strike over private equity mandated pension cuts. Kraft will refuse pay rises to any Cadbury workers not ‘opting’ out of its defined benefit scheme. An independent study of Californian state pension liabilities came up with a deficit of $500bn by using an assumed rate of return of 4.1% vs. the actuarial guess of 8%. Qinetiq is trying to unilaterally renege on employees termination benefits agreed on privatisation. All of this was in the papers over the last three days. Consumer confidence will not return to pre-Lehman levels if workers think they will be impoverished on retirement. Enthusiasm over a stabilisation of US unemployment at circa 17% (counting all of the non-working population correctly) should be taken with several buckets of salt.

The other events of the last few days involve an acceleration in the pace of corporate activity – Newcrest’s bid for Lihir and Peabody’s bid for Macarthur coal. We expect the pace of corporate activity in the resource arena to remain high as the race to secure supplies or hedge price risk intensifies. Given the recent moves by India to use sovereign funds to acquire energy assets alongside the listed ONGC and Oil India, prices are likely to go higher still. Own the targets.

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