- Last week proved to be momentous on several counts, starting with a massive €750bn financial rescue package for the eurozone by the EU & IMF
- The deal was deemed sufficient to restore confidence to the bond markets, provide sufficient liquidity for the banking system and avoid contagion
- On the back of this global equity and bond markets rallied strongly
- Here in the UK the Conservatives formed a coalition government with the Liberal Democrats and immediately announced a £6bn cut in the deficit
- In Europe, Spain and Portugal followed in the footsteps of Ireland and Greece by announcing swingeing cuts in public spending as part of their own austerity measures
- History seems to be on the side of UK equities even though we too will have to endure cuts in government spending according to a report by Goldman Sachs
- Investors are being urged to diversify their portfolios to include lower risk funds
- George Luckraft of AXA Framlington gives an insight into his portfolio and explains why he is optimistic about the outlook
The quantum theory is the idea that a small change can lead to something much larger happening and undeniably that was true of UK politics last week, with the formal coalition between the Conservatives and the much smaller Liberal Democrat parliamentary party. So what will it all mean? Well, the financial markets’ initial reaction was somewhat obscured by more pressing events in the eurozone region last week, where fears of contagion had reached boiling point the previous weekend. There were serious concerns amongst Europe’s leaders that government bond markets could collapse and credit markets freeze up as investors’ concerns over indebtedness took hold. As it transpired, world financial markets rallied on Monday following the announcement of a massive – and for the most part unexpected – €750bn rescue package put together by the European Union and International Monetary Fund. The scale of the rescue saw off the speculators, enabled the euro to soar, gave sovereign bonds their largest one day boost for 11 years and propelled international stock markets sharply higher.
Unsurprisingly, the surge was most dramatic in Greece, where the crisis began in October last year, after the government admitted that its budget figures were far worse than previously reported. Whilst there was clear relief amongst investors, an air of caution was still palpable: details of the rescue package were unclear and the actual work of reducing burgeoning budget deficits yet to be tackled. There was also concern, according to The Financial Times, over perceived political influence by eurozone leaders, which resulted in the usually independent European Central Bank riding to the rescue of the bond markets by announcing its own form of quantitative easing. The new policy effectively allows the ECB to buy any eurozone bonds on an undisclosed scale and to step up the provision of unlimited emergency liquidity to banks.
Once the dust began to settle it also emerged that the US had made it clear that it was not pleased with the original eurozone rescue package. US Treasury Secretary Tim Geithner told his European counterparts that the intervention was not in the “right order of magnitude”. Mr Geithner’s forcefulness stemmed from escalating fears within the Obama administration and the US Federal Reserve that the US recovery might be under threat from the spreading European sovereign debt crisis. So, rather than rely on the quantum effect, the EU went for the big bang approach – and it succeeded, with one fund manager at M&G commenting “ We have seen spectacular rallies in many markets. This support package has taken the fear away”.
Meanwhile, back in the UK, news that David Cameron was to become Prime Minister gave sterling a much needed boost as he promised “strong and stable” leadership. According to The Daily Telegraph, despite fears that a hung parliament would be catastrophic for the UK economy, the pound jumped to $1.50 and shares rallied. The new coalition government pledged to hold an emergency Budget within two months, which is likely to include the harshest austerity measures imposed on Britain in post-war history. The CBI gave its support to the new administration and said the “overriding priority” was to restore fiscal stability. The Chancellor, George Osborne, wasted no time in announcing an immediate £6bn cut in public spending, mostly from efficiency savings. According to The Times, the government took the unusual step of seeking the Bank of England’s approval for its strategy and its governor, Mervyn King, publically endorsed the measure. It wasn’t just Mr King who approved; institutional investors gave the thumbs up to the proposed squeeze too, enabling the Treasury to sell £2.5bn worth of gilts, attracting the highest level of demand for UK government debt since 2004.
But investor support for sterling and gilts was not solely attributable to the new government – hopes that the economic recovery is gathering momentum were also boosted by upbeat economic figures. Industrial output in March jumped at its fastest rate for eight years, up 2.3% and surprising economists who had expected just 0.4%, and will result in a 0.1% upward revision of first quarter GDP growth, according to the Office for National Statistics (ONS). Shoppers and homebuyers are also continuing to spend too – latest data showed retail sales rose 3.8% in the three months to April, according to the British Retail Consortium and more estate agents are reporting rising house prices, according to the Royal Institution of Chartered Surveyors. The only fly in the ointment last week came in the form of news that British exports failed to keep pace with a sharp rise in imports during March – the ONS said the trade gap rose to £7.5bn, up from £6.3bn in February. Fears were expressed that recent events in the eurozone clearly cast a shadow over the longer-term prospects for UK exporters, said The Times.
Pound of Flesh
As last week showed, global investors are sending a simple, if not painful, message to Europe’s indebted countries – cut your budget deficits or else. Greece has been forced to introduce a package of measures that will result in severe austerity – rather appropriately the word comes from the Greek word, austêros, meaning harsh. But the pain has also moved to Spain – public sector workers were rudely awakened last week by a cold bath of pay cuts and a pension freeze as the government bowed to pressure from the bond markets to adopt drastic solutions to its debt problems. Following hard on the heels of Greece, Ireland and Spain was Portugal, which last week also announced tough new measures, including a ‘crisis tax’ on wages and large businesses, as part of a plan to halve its budget deficit in two years.
The moves are an obvious outcome of the recent turmoil and seen as necessary to convince financial markets that the most heavily indebted countries are serious about tackling their deficits. The scale of the problem varies from country to country and investors use government budget deficits as a percentage of GDP to gauge the relative size of the task to be tackled. To put the numbers in perspective, Portugal’s deficit is currently 9.4% of GDP, Ireland’s 14.3%, in Greece it’s 13.6% and 11.2% in Spain. Here in the UK, according to ONS data, our deficit is 12.2%, which explains why George Osborne sees addressing the deficit as an imperative for the new government.
So by the end of the week, global financial markets had factored in the huge EU bailout, a new coalition government in the UK and a series of austerity budgets from some of the eurozone’s most indebted countries. The net result was that all of the world’s leading equity indices made solid gains, not withstanding a last minute wobble on Friday, with London up over 2% for the week – much in line with most other bourses.
Whilst everyone is acutely aware of the scale of the problems that lie ahead, it doesn’t necessarily follow that it won’t be possible for equity markets to make progress. Research from Goldman Sachs finds that periods of “fiscal adjustment” need not prove a hurdle to the UK stock market. The Times found the evidence “persuasive”. Goldman has identified three periods in the last 40 years when the UK budget deficit has been cut significantly and in each case UK equities significantly outperformed the rest of the world. Currently, based on a comparison of price-earnings ratios, UK shares are around 30% cheaper than in the rest of the world. Crucially, each episode was also preceded by a fall in the value of the pound. Whilst there is no guarantee the same will happen this time, if investors become convinced that a stable government has grasped the fiscal nettle then UK equities could move higher.
Of course, there is the issue of higher taxation for investors to consider – the government has announced already that the rate of Capital Gains Tax on ‘non-business assets’ (such as shares, collective investments and second properties) is due to rise significantly in the next tax year and planning is needed. If shares do move higher there will continue to be volatility, said The Sunday Times, which advised investors to diversify their portfolios to include what are perceived to be lower risk investments such as Absolute Return funds, Cautious Managed funds and Multi-Asset funds.
A Global View
So with UK shares relatively cheap to overseas equities, what do the professionals think? George Luckraft is an experienced UK equity manager at AXA Framlington and here he shares his views on the outlook. “My portfolio currently yields around 4.3% which is about 1% above the yield on the UK market as a whole and 60% of that income comes from the top ten stocks such as BP. However, around half the portfolio is invested in smaller company stocks because this part of the market is the most inefficient in terms of knowledge and research, thus giving greater opportunity to find undervalued companies. It is also the unloved part of the market for all sorts of reasons – not least of which is investor aversion to risk following the credit crisis. So I’m very positive about the prospects for this sector going forward.
“The general election outcome is in my opinion just short-term noise – we operate in a global market which is predominantly capitalist based, which means most governments are unlikely to do anything fundamental to alienate business. Whilst I am somewhat pessimistic on the outlook for the UK economy, that does not mean that there are no opportunities to be captured from owning British stocks. It’s important to remember that around 75% of corporate earnings in total come from overseas. Within my small cap stocks, the figure is still around 60% and much of this is directly or indirectly from emerging markets. Here in the UK, businesses are in better shape than most realise. Despite some companies experiencing a 20% downturn in business volumes, margins are very high because they have dramatically cut their cost base, so any small improvement in earnings feeds straight through to profits.
“Of the smaller companies I own their business models are much diversified. Deveraux makes sausage skins but operates on a global basis, so is a play on emerging markets and increased consumption of protein. Vitrex exports 98% of its high performance plastic products almost equally between the US, Europe and Far East – it is enjoying increased business on a lower cost base and higher margins. This is the type of company I like, operating in a cash generative but fragmented sector where ultimately value is added via consolidation. So whilst I think large cap stocks may face headwinds in the form of higher government taxes over the next five years, there is still plenty of real opportunity that exists in the small, medium cap sectors and I’m confident these can be exploited”.