Equity/gilt yields provide strongest buy signal from UK market

This week:

  • Sovereign debt crisis sparks sell-off
  • Unilateral German action to ban short-selling shocks investors
  • Senate backs US banking reform bill – Wall Street “joyride” coming to an end
  • Equity/gilt yields provide strongest buy signal from UK market since 2003
  • Latest inflation figures confirm biggest cost of living increase since 1991
  • Speculation over capital gains tax reforms in June emergency budget

German stab in the dark
Is it right to say that for Lehman Brothers read Greece and for Hank Paulson read Angela Merkel? Indeed, is it right to say for September 2008 read May 2010? We do not believe so despite these comparisons being made by The Guardian. In a week that saw the euro falling and shares plunging as investors stampeded into the safe haven of bonds, fears rose that policy responses to Europe’s sovereign debt crisis could undermine the global recovery and trigger a double-dip recession, it is all too easy for investors to jump the wrong way. True, a wave of selling hit risky assets last week, sending equities, commodities and high-yielding currencies tumbling sharply from April highs. As The Financial Times opined, confidence was shattered by fears of a disorderly crackdown on banks and financial markets indicated by an apparent lack of clarity from politicians. A hammer blow came from the announcement by Angela Merkel, Germany’s chancellor, of a unilateral and totally unexpected ban on naked short-selling of certain securities – the practice of selling securities such as shares or bonds that are not owned or borrowed. This left investors both fearful at the air of panic conveyed by the move and dismayed at the lack of co-ordination with other policymakers. In an interesting defence of the move, Wolfgang Schäuble, the finance minister, told reporters, “If you want to drain a swamp, you don’t ask the frogs for an objective assessment of the situation.”

Investors’ concerns were also pulled first in one direction and then the other by developments on the other side of the Atlantic, where President Obama’s administration received approval for its 1,500- page Restoring American Financial Security Act, putting the US on track for its biggest overhaul of financial regulation since the 1930s, according to The Times. The Senate Bill would create a new consumer financial protection agency, as well as a council of existing regulators to look out for so-called systematic risks – such as the easy loans that fuelled America’s devastating housing bubble. Regulators would be given power to close and liquidate failing financial companies considered “too big to fail”, saving taxpayers from further bailouts. Wall Street banks had lobbied hard against the reforms, which would severely limit their ability to trade with their own money and force them to spin off lucrative derivatives businesses. US bank shares slumped on Friday as investors worried that their profits would be hit, but they rebounded later as markets adjusted to a new reality that may hit profits in some sectors, but at least reduces uncertainty.

In response to these events, the Vix volatility index, renowned as the market’s “fear gauge”, approached 50, its highest level since March 2009. Less than six weeks ago the indicator hit a three-year low of 15.23.

According to The Financial Times, the sense of crisis in the currency markets reached fever pitch following the German announcement, as investors turned to shorting the euro as a means of betting against the eurozone economy. The single currency tumbled to a 4 year low against the dollar at one stage during the week and has lost 12% of its value against that currency since the start of the year. The European Central Bank (ECB) president Jean-Claude Trichet refused to discuss whether they had intervened to prop up the euro, according to The Guardian, but insisted that the currency was not in danger despite the anxiety caused by the prospect of the crisis in Greece spreading across the eurozone. “Market movements are always a combination of the mood of investors and influence of speculative investors like hedge funds”, M. Trichet said.

In their Friday markets update, Capital Economics acknowledged that tensions in the money markets were building, but were a far cry from the liquidity crisis in the days before Lehman Brothers collapsed in September 2008. The rate charged by banks to lend to each other US dollars for three months has risen to its highest level since July 2009, but the money markets are continuing to function relatively smoothly. Part of the reason for this relative calm is a healthier and better-capitalised banking system. Despite the Greek crisis, the cost of insuring against a default by banks – even in the eurozone – remains less than it was in the spring of last year. More important, though, has been the continued provision of massive amounts of liquidity by monetary authorities.

It was a week of sobering statistics. The FTSE 100 index finished the week down -4.95%, having briefly dipped below the 5,000 level on Friday for the first time since November, before finishing little changed at 5062.93. This represents a drop of -13% since its peak in April. The FTSE Eurofirst 300 index was also down -4.40% on the week, although markets across Europe recovered in late trading on Friday as German politicians backed their part in the $1 trillion package constructed by euro members to prevent re-runs of the Greek catastrophe. The Japanese Nikkei 225 index had its worst week for 15 months, closing below 10,000 for the first time since February. In the US, the S&P500 index reached correction territory, having fallen more than 10% from its recent high, the definition of such an event and the first of the bull market that began in March 2009. However, brighter signs appeared on Friday as the financial sector rallied after the US Senate finished its work on the regulatory reform bill.

Yet for all the negatives there are still plenty of positives and a strong sense that the stock market has over reacted and is now discounting a lot of bad news. On the domestic scene, Britain’s gross domestic product growth for the first quarter, initially estimated at only 0.2%, is set for an upwards revision this week after news of a strong bounce in manufacturing in March, according to The Sunday Times. This follows figures last week showing a 6% rise in business investment in the first quarter and a £7.5bn downward revision of Britain’s budget deficit for the 2009-10 fiscal year.

The recovery is being led by Asia, which is showing few signs of slowing in spite of recent tightening measures, while the US is showing signs of momentum. Mick Gilligan at Killik, the broker, said: “The latest US quarterly reporting season has been one of the best on record, with more than 80% of companies beating expectations. The picture in Europe and the UK is also strong.”

As The Financial Times confirmed, taking into account the prospect of slower growth in the eurozone, “Citigroup still expects global GDP growth of around 3.8% this year and 3.4% next. If those forecasts are achieved, UK share prices would be 30% higher than they are now.”

The point of no return
Just as risk aversion in the markets was heightening, last week’s announcement of the latest inflation figures in the UK provided another jolt for savers resorting to the perceived safety of deposits. The cost of living saw its biggest rise since 1991, and that’s before the new government publishes its emergency Budget, which is expected to hit our pockets with rises in National Insurance, VAT and capital gains tax. The consumer prices index (CPI) rose 3.7% over the year, while the retail prices index (RPI), which includes mortgage costs and house prices, rose 5.3%. As The Times reported, based on the CPI figure, this means a basic-rate taxpayer needs to find an account paying at least 4.63% to break even – a rate available on just 20 accounts on the market. For higher-rate taxpayers the figure needed is 6.17%. Using the RPI as a measure the statistics are even starker – there are no currently available accounts paying the 6.6% that would be needed by a basic-rate taxpayer. However, those in search of those 20 accounts may still be disappointed, as The Daily Telegraph picked up the theme and went on to report that most of those are regular savings accounts or fixed rate bonds requiring matched investment in riskier schemes.

Fundamental values
The article reiterated the fact that those hoping to beat inflation have to be prepared to accept some risk and highlighted the long-term track record of dividend paying shares and equity income funds. After a dismal period of dividend cuts over the last couple of years, most notably from the banks which are traditionally big dividend payers, payouts are on the rise. Some 186 companies paid a dividend between January and March, up from 161 a year ago. Whilst an encouraging trend, many fund managers have retained a focus on those companies that have continued to offer dividend growth over the past number of years. These are companies with strong balance sheets and relatively resilient cash flows, which have been able to trade through recent uncertain times. Amongst those managers is Neil Woodford of Invesco Perpetual and, in a separate article, The Daily Telegraph highlighted his impressive longer term performance and his continued belief in the current value offered by those companies that have been overlooked in recent times in favour of more momentum-driven, cyclical stocks. Neil Woodford also manages funds for St. James’s Place.

Time to invest?
The Sunday Times continued the dividend yield theme in the aftermath of the week’s turmoil and pointed out to readers that shares are giving their strongest buy signal since 2003. In urging investors to hold tight despite last week’s volatility and not discounting the possibility of further short-term falls, it reported that shares are now as cheap relative to gilts than they were in 2003. In fact they have only been cheaper on this measure in March 2009 and back in 1965. Adrian Cattley at Citigroup was quoted: “We are at a crossroads – UK equities are yielding more than gilts and this was a clear buy signal in 2003.” Many analysts share the view that this correction is a buying opportunity. Figures from JO Hambro Capital Management showed the FTSE All Share index has a historic dividend yield of 3.65% against 3.52% from 10-year gilts. Gilts normally yield more than equities on the basis that investors should get more income to compensate for lower growth.

Spreading the load
The volatility in markets last week was a further reminder, if one were necessary, of the importance of asset class diversification within an investment portfolio. Since the beginning of April, the FTSE Allshare has fallen in value by a shade under 10%, while equities worldwide have fallen by 5.5%. Compared to this, and to potentially add protection to the falls, the value of corporate bonds has risen around 1%, as has the value of Commercial Property. In contrast to this, UK Gilts have actually risen 3.6% over this period.

Taxing times
In the light of the impending emergency Budget of the new coalition government, the press debated the merits or otherwise of the anticipated increase in capital gains tax (CGT) rates on ‘non-business assets’. The government has stated its intention to raise CGT from 18% to rates “similar or close to those applied to income”, in apparent agreement with the stance taken by Nigel Lawson, the former chancellor, when he raised the CGT rate from 30% to 40% in 1988. The Sunday Telegraph reported the clamour within the investment community against a ‘one go’ increase from 18% to as high as 50%, with the attendant dilemma of whether to sell assets before the Budget to avoid a potential doubling of their tax bill. The article advocated proposals that would at least take into account inflationary growth (via “indexation”) or for some tax relief to ensure that long-term investors are not penalised unfairly – a move reflected in alternative plans produced by 30 Tory MPs who have proposed an exemption on all gains of more than five years.

The Sunday Times further reported debate between the Tories and Liberal Democrats over whether to reduce the CGT annual allowance from its present £10,100 to around £2,000. However, Chris Sanger, head of tax policy at Ernst & Young made the point that it would be a false economy to catch a wider swathe of people in the CGT net: “The annual exemption limit was designed to make an administrative saving – lowering it would negate that because the Treasury would have to employ more staff to deal with the deluge of additional paperwork.” The article went on to point out that, given the likely future direction of CGT, the opportunity to shelter £10,200 each year in an ISA shouldn’t be underestimated, nor the savings to be made through Enterprise Investment Schemes (EIS) and Venture Capital Trusts (VCT). What is clear is that everyone will have to wait until 22nd June and the emergency Budget to know for sure.

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