In this week’s Bulletin:
- The five largest banking institutions in the UK report half-year profits
- Equity markets closed the week ahead, despite disappointing US economic data
- The strong pound hits London properties
- Analysts predict a gloomy inflation report from The Bank of England
- Bernie Horn, of Polaris Capital Management, gives his views on the long-term opportunities in equity markets
Banking profits on the rise
Taking the high-profile headlines were the biggest UK banks, as the robustness of the British banking industry was highlighted in a week where the five largest UK institutions reported half-year pre-tax profits of £15 billion. As reported in The Financial Times, the revival in fortunes was in stark contrast to 12 months ago, when the sector was reeling from billions of pounds of impaired loans and uncertainty over the extent of the government bail-outs. While the government is highly unlikely to start selling down its stakes until next year, even though the share prices are above the levels that the government paid for its stake, the recovery of Lloyds and RBS is a positive signal that taxpayers will eventually claw back a return from their £62 billion investments in the two banks. UBS calculate that between 2012 and 2014, Lloyds could pay out £15 billion in dividends while still retaining £30 billion more capital than it needs to meet regulatory requirements.
RBS, which is around 80% state-owned, revealed a first half net profit for the first time in three years, with profits of £9 billion compared to a loss 12 months ago of £1 billion, as bad debts fell and margins rose in its retail and commercial operations. But have things actually improved and is this good news for the general public? Certainly not as far as The Mail On Sunday is concerned, as the paper pointed out that in the past year, not much has changed. Using somewhat emotional language, the paper opined that savings rates are “excruciatingly low” and the banks are making bigger margins at the expense of their borrowers, treating their customers as “exploitable fodder”. In rather less emotive terms, The Sunday Times also stated that it is borrowers that are paying for bank profits, with margins for three and five year fixed-rate mortgages rising significantly over the 12 month period. The margins measured show the difference between the rate the banks charge the borrower, and the cost to the bank of securing the mortgage funding on the wholesale market. In addition, Vince Cable, the Business Secretary, warned that there were two major issues with regard to banks at present, “At the moment, the great danger is that recovery is choked off by a lack of funds. The other issue is that the big banks seem structurally dangerous.”
UK banks are being forced to meet tougher rules on capital and liquidity as well as a new levy on their balance sheets whilst also, of course, being encouraged to lend more. Standard Chartered and Barclays last week both declared that they would consider leaving the UK market if they felt it was becoming uncompetitive. The chief executive of RBS, Stephen Hester, stated that it was “most unlikely” that RBS would quit the UK, but that the government must understand that financial services was one of the areas in which the UK can best compete.
Optimism v Pessimism
The FTSE 100 finished the week in positive territory, but once again failed to close above 5,400 due to a fall on Friday following the release of US economic data that painted a gloomy outlook for the US recovery. The number of American workers who lost their jobs in July was higher than expected, with the US Labor Department calculations that 131,000 jobs were lost against expectations of 65,000. This disappointing data prompted concerns that the Federal Reserve may have to take further steps to stimulate economic growth. The Times also reported on a survey that the recovery in the world’s leading economies may well have peaked. In a sign that British growth may be easing, the National Institute of Economic and Social Research said that GDP growth had slowed to 0.9% for the three months to the end of July.
Overall, equity markets showed some sort of resilience over the week buoyed by positive earnings news from European banks. Wall Street stocks and European equities closed the week a little under 1% ahead, while Japanese stocks rose for a third consecutive week. Globally, the biggest winners were Hong Kong and China, rising 3.1% and 1.4% respectively. Within currency markets, the stubbornly weak recovery in the US left the dollar as the world’s least popular currency for the week, compounding the 10% decline against a range of currencies since the start of June on a trade-weighted basis. The US currency fell to a 15 year low against the Japanese yen, and helped push short-dated Treasury yields to their lowest on record at 0.5%. The strength of the yen prompted more speculation that the Bank of Japan might ease policy even further, while the 10-year Japanese government bond yield fell below 1% for the first time since 2003.
One asset class did have a strong week ─ gold prices rose as the economic concerns sent investors turning to the precious metal once again as demand soared. The negative sentiment helped bullion rebound above US$1,210 per ounce for the first time in a month.
Mixed fortunes for property
Commercial property prices in the UK are continuing to rise, according to The Financial Times, driven by increasing demand. Prices for retail, office, and commercial buildings have been rising since September last year, and figures from the Investment Management Association show that private investors saw Property funds as attractive again after shunning the sector for 12 months. The general consensus among analysts however, is that capital growth could be slower than in recent times, and that income is likely to make up the bulk of investor returns for the second half of 2010.
Foreign investors keen to buy at the bottom of the market began buying prime London residential properties last autumn, but recently that sharp recovery has stalled somewhat following 15 consecutive months of price gains. Prices for prime London property fell 0.5% in July, the first monthly decline since March 2009, with analysts blaming this on falling demand from foreign investors after the increasing value of sterling (including a 10% move against the dollar in just two months). It is thought that buyers from the Eurozone, Hong Kong and the Middle East were able to achieve effective reductions of 30─50% on London house purchases, thanks to the relative strength of their domestic currencies.
Inflation on the horizon
There was speculation in The Sunday Times that the Bank of England’s quarterly inflation report, due out this week, will include the grim combination of low growth and rising prices for the next 18 months. The forecasts are set to show that inflation, which has been above the official target of 2% since 2006, will remain above this level for the foreseeable future after George Osborne announced the increase in VAT to 20% from January 2011 onwards. However, it is the Bank of England’s growth forecast that is likely to unsettle the most. Last month, it predicted 3.4% growth next year and 3.6% in 2012, but this week it is expected they will remove a whole percentage point from these forecasts.
A report in The Mail on Sunday suggested that high street prices are set to rise throughout the year as retailers are hit by higher manufacturing costs, and the impending rise in VAT is passed on to customers. Clothing retailers Next and Marks & Spencer both warned this week that shoppers would soon see increasing prices, after the entire retail industry has seen a range of increased costs such as the price of fabric, particularly cotton which has risen by 60% in 12 months. Other factors weighing against consumers are transportation costs, with fuel prices being 10% higher, and enhanced labour costs.
Historically, one of the better ways to combat any threat of inflation over the long term is through investment in equities. One advocate of this approach is Bernie Horn of Polaris Capital Management, manager of the SJP Worldwide Managed funds, who is confident there are significant opportunities in equity markets despite the recent doubts over economic recovery. Bernie recently reported: “Our conversations with companies worldwide indicate further mixed economic progress. Some industries and countries are stabilising, while others are experiencing only sparse improvement. Inventory cycles appear ambiguous. Economic growth remains modest to stagnant in developing countries, while emerging market demand appears strong and sustainable. Since we are concerned about uneven economic growth, we are attempting to reduce portfolio exposure to countries or sectors facing a protracted recovery. Over the past few years we have made a conscious effort to minimize portfolio risk, increasing defensive positions in energy, utilities and healthcare to better balance the portfolio and reduce cyclical exposure. In healthcare, we recently bought a U.S. company, Questcor Pharmaceuticals, that manufactures ACTH, an orphan drug effective for infantile spasms and numerous other diseases, and a French biotech company, Transgene SA, designing therapeutic vaccines for pre-cancerous cervical lesions, non-small cell lung cancer and Hepatitis C.
Information technology also offers an interesting value proposition, as we identified numerous companies with strong free cash flow, promising growth and cash rich balances sheets with little debt. New investments included Wincor Nixdorf, a German manufacturer of banking machines and point of sale hardware and software, and Brooks Automation, a U.S. based company that serves the semiconductor industry.
Economic ambiguity expected throughout this year creates more normalised market volatility – unlike the abnormal upward trajectory evidenced in the 1990s─2000s. Faced with normal volatility, we remain steadfast to the pure value investment strategy that governs the portfolio. We harvest gains in more cyclical companies, hold cash as a buffer, and reinvest in new purchases when the markets undervalue fundamentally strong stocks. Maintaining this buy/sell discipline over these past twelve months has proved advantageous, and we intend to continue executing this strategy in an effort to achieve benchmark-beating returns with lower than market risk. We will continue to buy opportunistically, taking advantages of volatility to purchase positions in down markets and reduce positions in market advances.”