In this week’s bulletin:

  • Alistair Darling was given a boost last week when it emerged that tax revenues were better than expected which may allow him to cut the deficit more than expected in this week’s Budget.
  • Gilt prices rallied as a consequence but sterling fell as foreign investors fretted over the possibility of him using the money to boost Labour’s spending plans.
  • Global markets enjoyed a steady week, helped by comments from US Federal Reserve Chairman Ben Bernanke who said interest rates would continue to remain close to zero for an extended period.
  • The outlook for China’s growth remains very good for the next two years according to the World Bank – conversely, the European Commission told Germany, France, Italy and Spain that their growth forecasts were too optimistic.
  • With the likelihood of higher taxes ahead investors are being advised to make the most of this year’s allowances before it’s too late.
  • Andrew Green of GAM gives an insight into his current portfolio strategy.

Darling’s Windfall
Just days from his last Budget before the impending general election, the Chancellor was handed a windfall when official data released showed that tax receipts had not fallen as much as had been feared during December. The net outcome is that public spending, whilst on target for the year, will be in the red by about £170bn versus a pre-Budget forecast of £177.6bn. Alongside this the Treasury is to announce a significant cut in the amount of debt (via the issue of gilts) it will have to sell in the coming tax year – around £170bn – compared to the gargantuan £225bn this year. The press speculated that the improved revenues and borrowing forecasts will enable Alistair Darling to send a ‘steady as she goes’ message as the recovery continues, using some of the windfall to repay debt but also spend some of it on measures to demonstrate Labour’s agenda for a fourth term. To counter this though, Lord Mandelson admitted that taxes might have to rise further after the election, despite the improved financial outlook.

To add to the mix, Lloyds Banking Group – in which the government has a 41% shareholding – issued an impromptu statement to the market saying it is set to return to profit this year; earlier than expected. As Lloyds’ shares jumped 9% the news increased the chance of UK Financial Investments (which manages the government’s holding) to expedite plans to sell a first tranche of that stake, thus helping government finances. The better news on borrowing, together with benign inflation data, gave gilt prices a fillip with yields falling to just under 4% as buyers demonstrated their interest in longer-dated paper. Foreign investors were less convinced though and voted with their feet, selling the pound as they fretted about the prospects of double dip recession and worries that Mr Darling may not spend his tax boost wisely. After an initial boost earlier in the week, sterling fell back by 2.3 cents to end the week at $1.50, while the euro strengthened back above the 90 pence level.

One final piece of good news emerged when the Bank of England said its controversial Quantitative Easing (QE) policy had helped reduce the government’s cost of borrowing by a full one percent through its gilt purchases. QE has finished for now but could be revived by the BoE if the economy fails to gain traction – deputy BoE governor Charles Bean said “The road ahead is likely to be bumpy and there is still the risk of further adverse shocks”. And figures released last week illustrated the stark contrast of how the pain of the recession has been felt across the employment field. Whilst the overall number of unemployed fell by 33,000 in the three months to January to 2.45m, the figures showed that public sector employment rose by 7,000 during the period while private sector employment fell by 61,000. Head of public sector business at KPMG Alan Downey commented that the data “just underlined the chasm between the experience of the public and private sectors in the recession.”

Bernanke Rally
Global equity markets and commodity prices rallied last week after the US Federal Reserve’s signal on Tuesday that American interest rates would continue to remain close to zero. Chairman Ben Bernanke re-iterated previous policy, saying that, although the outlook for the US economy was more upbeat, interest rates would remain low for an “extended period”. Equity markets around the world moved higher with many of the large indices hitting fresh highs since the lows witnessed in March last year. Reinforcing the improved sentiment, the Vix index, a measure of market volatility and seen as a good gauge of investor expectations, fell to 16.54 – its lowest level since May 2008.

Over in the East, the outlook for the world’s most dynamic economy, China, continues to look good. Last week the World Bank raised its growth forecast for this year to 9.5%, although it warned that tighter monetary policy and a stronger currency were needed to prevent asset bubbles and rising inflationary expectations. “China’s economy held up well in the global crisis and the growth prospects for this year and next are quite good” said the Bank’s economist in Beijing. The same cannot be said though for the eurozone’s four largest economies, according to the European Commission, which warned Germany, France, Italy and Spain that their growth forecasts for the next three years are too optimistic. The four had responded to the Commission’s request for details of how they were going to tackle deficit reductions. Brussels delivered its warning just two days after eurozone finance ministers broke new ground by declaring they were ready to set up a standby lending facility for Greece to help overcome its crisis. So by the end of the week equity markets finished modestly higher, consolidating the gains seen in recent weeks.

Rush to Beat Tax Rises
Investors are rushing to shelter their income and capital before the end of the tax year amid fears that taxpayers will come under fire whichever party wins the election, according to The Sunday Times. Many companies – including the likes of Tesco – are paying bonuses to higher-earning staff to avoid the new 50p rate due to take effect in April. Investors are being advised to take maximum advantage of this year’s Individual Savings Allowance – currently £7,200 or £10,200 for those aged 50 or over – to shelter assets from Capital Gains Tax (CGT) and higher rates of income tax. Fears that CGT may be increased from its current level of 18% are also leading some investors to crystallise gains now with a view to re-basing their investments going forward or in some cases re-investing in tax-saving schemes such as EIS and VCTs. Speaking to The Sunday Telegraph, accountants Grant Thornton said “The next few years are going to be tough, but we may as well protect ourselves as well as we can from the harsh reach of the taxman.”

The need for HMRC to increase its share of the tax take was highlighted last week when it was announced that the Revenue is trawling the Land Registry to identify people who have bought and sold properties without telling the taxman. The Times also pointed out that HMRC is also looking closely at second-home owners who have claimed maintenance costs in an attempt to reduce their CGT bill. Doctors are also in their sights – HMRC has written to 28,000 doctors and consultants inviting them to disclose whether they have any undeclared taxable income. So with just a few days left before the end of the tax year it makes sense to utilise as many available allowances as possible.

A Rising Sun?
Global fund manager Andrew Green of GAM is well known for his deeply contrarian approach to investing which often results in him taking positions in stocks which are out of fashion with mainstream investors. Whilst the approach has been very successful over the long term, it often requires a great deal of patience as Andrew waits for the markets to catch-up with his own views on where future growth prospects lie. His expectations of a revival in the world’s second largest economy, Japan, have been frustrated by weak share prices and a strong currency, but he explains why he now feels more confident. “The outlook for the UK economy is obviously occupying people’s minds at present but I think the recent decline in sterling reflects investors’ concerns about the outcome of the forthcoming general election, although it is quite possible that the pound could fall further. However, for the commodity-based currencies – for example the Australian and Canadian dollars, the worst of any downside is over. The low growth environment outlook for the UK is unsurprising given the fact that British knowledge-based sectors are suffering and the economy cannot compete with cost-driven emerging markets.

“Part of my strategy over the last two years or so has been focused on the revival of technology stocks, an increase in weighting in the US and a revival in the Japanese equity market. On the former, technology stocks have begun what I see as a longer-term recovery as businesses seek to cut costs, so the portfolio has benefitted from a re-rating of companies like Unisys following the crisis, when the stock fell as low as $2 (from $20) and is currently around $28. Indeed, the portfolio’s exposure to the US was increased from around 6% to nearer 20%, which has been positive.

Unfortunately, the relatively good performance of some of my stocks in Japan – particularly in the banking sector – has not fed through because of the currency hedge and a weak stock market in general has deterred potential investors. I think Japanese banks are particularly cheap at present – I own Nomura and Sumitomo – because they are, unlike Western banks, awash with cash with nowhere to invest. I think the latter point will lead to more Japanese banks buying up Western banking assets as they did in the midst of the financial crisis – after all, the UK government is keen to sell their equity at a profit and the likes of Sumitomo are well placed to buy these assets. One of the reasons for the yen’s strength is that the Japanese government doesn’t have to sell its bonds to overseas investors – 95% of government funding is sourced internally, unlike the UK or US which rely heavily on foreign investors. But where I see the opportunity now is that the Japanese market is poised for a large, upward move in the coming months.

On the US front, the higher weighting has helped and here again banking stocks have performed well – Citigroup shows a good profit as do the pharmaceutical and other recovery stocks I own. In Europe my reading of the situation is that, relative to sterling, European assets are overpriced: so one of two things could happen. Either equities are overpriced and need to fall, which I don’t think is the case, or the euro falls in value which I think is quite likely. So here and now the portfolio is diversified across some 120 stocks but also by geography – with around 20% of the assets in Japan – and positioned for continued global recovery, albeit slow. It is worth remembering though that a slow recovery is good for the stock market because what happens is that businesses cut costs and are wary about investing for organic expansion, so the cash stays on balance sheet or is invested through acquisitions and other stock market-related activity. Following ten years of relatively poor performance from global equity markets, I feel far more confident about the outlook now than I have for a very long time.”

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