In this week’s bulletin:
- Last week the Irish crisis dominated financial markets but the final eurozone bail-out was never in doubt so its formal announcement had little impact.
- With the certainty of knowing the Irish problem would be addressed, international investors turned their sights on Portugal causing the cost of government debt to soar.
- Endeavouring to stay ahead the Portuguese government announced a new austerity package which co-incided with a national one-day strike.
- Elsewhere Japan’s export-led recovery seemed in doubt following disappointing trade data and Chinese stock markets remained volatile in anticipation of further interest-rate rises.
- With UK equities lowly priced and investors worried about income and inflation the press highlighted the merits of dividends. UK fund manager Neil Woodford explains why his portfolio is so concentrated around a smaller number of high-quality, high dividend-paying companies.
Using the Greek crisis as a template, the week unfolded in a pretty predictable way for the eurozone’s latest victim, Ireland. Following initial protestations from the Irish premier that the country was sufficiently well financed until the middle of next year and that it would not need to tap the EU/IMF bail-out fund, the administration performed an exemplary volte face. By the beginning of last week it was a done deal, with only the finer detail to be sorted following agreement by European finance ministers to grant Ireland’s request for a multi-billion euro emergency rescue – thought to initially total around €80bn–€90bn. The rescue was driven by the need to assist the country’s debt-ravaged banks and to prevent contagion from destabilising the entire 16-nation eurozone. However, as The Financial Times pointed out, the deal put paid to Europe’s hopes that a ‘shock and awe’ €750bn backstop, arranged after a bail-out of Greece in May, would never need to be used.
By the end of the week, though, events took a twist when investors fretted that some bondholders might have to accept potential losses – mainly banks like RBS and Lloyds – particularly as the Irish government’s hopes of pushing through a further €15bn of austerity cuts were put in doubt following a by-election win by Sinn Fein. Over the weekend the EU announced an €85bn package – sufficient according to the French finance minister Christine Lagarde “because that will keep Ireland afloat for three years”. Irish Prime Minister Brian Cowen said that it was the “best available deal for Ireland”, providing “vital time and space to successfully and conclusively address the problems we’ve been dealing with since the financial crisis began.” In the government bond market, yields on ten-year bonds [used as a benchmark] in the Republic of Ireland, Portugal, Greece and Italy were largely unchanged as reaction to the bail-out was largely muted.
Once it became clear that Ireland’s woes would be addressed, international investors decided to look further afield for potential problems and the financial caravan moved on to Portugal. On Tuesday shares closed sharply down in both Portugal and Spain as fears grew that Europe’s sovereign debt panic would lead to the next bail-out centred on the Iberian Peninsula. Reflecting these concerns, the cost of borrowing for the eurozone’s peripheral economies rose to record highs as investors demanded a higher premium to offset the perceived risk of owning Irish, Portuguese and Spanish debt. Endeavouring to stay on the front foot, the Portuguese government announced a €5bn austerity budget for 2011 with the country’s prime minister saying his tough package would move Portugal “out of the danger zone”. The announcement coincided with a national strike which brought the country to a virtual standstill as people protested against the proposed 5% public sector pay cuts, reduced welfare payments and higher VAT. Speculation about whether the contagion could spread to Spain also heightened during the week, although most observers seem sceptical – Spain is the fourth largest country in the eurozone, accounting for about 10% of its economic output.
In the continuing aftermath of the banking crisis, European Union officials want liquidity ratios to be considered in a new round of Europe-wide bank stress tests as part of a plan to further stabilise the region’s banking sector. The previous exercise, conducted by the Committee of European Banking Supervisors, scrutinised and passed 84 of Europe’s 91 banks, including Bank of Ireland et al, but has been subject to criticism. Lord Turner, chairman of the UK’s FSA said, “We think the tests were useful exercises… the issue here is to work out whether these were liquidity or solvency problems.” There was speculation in the press that the eurozone’s emergency bail-out fund may not be enough, but Axel Weber, president of the Bundesbank, said the facility ought to be adequate, although if not, “it will have to be increased”. However, the German government took a firm line to quash any further speculation, saying it was a non-issue for Berlin. The country is the EU’s largest financial contributor and joint architect of the single-currency union.
Unlike many of its eurozone neighbours who are mired in slow economic recovery – recession in the case of Greece – Germany is enjoying robust growth, dubbed a ‘golden autumn’ by its economics minister Rainer Bruderle, who said the recovery was self-sustaining. His optimism is borne out by the latest German business confidence survey – the closely watched Ifo index of business sentiment. The index climbed to 109.3 this month – the highest level since data started after German re-unification. The rise was higher than expected and came just a day after data from factories and service companies suggested that growth was gathering pace – Germany’s third-quarter GDP growth was confirmed at 0.7%. German exports have responded strongly to changes in world demand, especially to the emerging market economies. There was further evidence to support a positive outlook for the major European economies, with data showing a rebound in bank lending to the private sector – up by an annualised 1.4% – the fastest since May 2009 according to the ECB.
Yen and Yuan
Away from continental Europe there was other news to occupy investors’ minds. In Japan, export growth fell sharply last month to 7.8%, resulting in another setback in the attempts to conquer deflation and secure a lasting – and frustratingly elusive – recovery. Whilst the official data confirmed the eleventh month of expansion, the rate was below expectations – the year-on-year growth rate recorded to September was almost double at 14.3% – reflecting the influence of a strong yen and low consumer confidence in Europe. Concerns are growing that corporate Japan will suffer from the extended strength of the yen. There was a bright spot though in the trade numbers; Japanese shipments to China were up 17.5% and the first surplus since the summer. However, economists were sceptical about the sustainability, alluding to the Chinese growth curve which is widely expected to flatten under efforts by Beijing to lower inflation.
They may have a point. Markets in Shanghai and Hong Kong have been very volatile of late as investors try to second-guess how savagely the Chinese authorities will wage war on inflation and the ‘hot money’ onslaught created by quantitative easing (QE) in the West. The Communist government has already increased rates twice in recent months in a bid to quell inflation and a property bubble. Last week, ten of the world’s largest investment banks updated their forecasts to incorporate another 0.25% rate rise by the Chinese central bank. “The Communist Party is looking even more concerned about inflation than growth,” commented one veteran to The Times. But it is a difficult balancing act for the Chinese, according to economists at RBS; if rates are pushed too far they will attract even more foreign cash inflows which will exacerbate current excess liquidity.
The impact of the US Federal Reserve’s latest round of QE was always going to be controversial – another $600bn of new money is to be created over coming months in an effort to stimulate America’s slower-than-expected economic recovery. Minutes released last week showed that the Fed acknowledged that their money-printing scheme could drive down the dollar. The minutes said that any currency effects would be “unwanted” but that QE2 could put “downward pressure on the dollar’s value in foreign exchange markets.” For example, the greenback has traded below ¥90 for some while now – helping boost America’s exporters’ competitiveness. The Fed’s desire to boost the economy is understandable given that unemployment remains stubbornly high at 9.6%, but it may well be that QE2 will be seen to be unnecessary in coming months. Data from the US Commerce Department showed that economic growth increased by 2.5% in the third quarter – up from 1.7% in the second quarter. But if all else fails there is always QE3, according to Standard Life’s global strategist Richard Batty. He suggests the Fed could think about printing $2,000 vouchers to give to Americans to spend if the US sinks into sustained deflation.
Whilst equity prices have been undeniably volatile over the last decade, one aspect of investing hasn’t changed – the power of re-invested dividends; a point made by commentators in the Sunday press. The Financial Times also pointed out that with inflation rising, a high quality portfolio of UK equities should allow investors to achieve a longer-term income return comfortably above inflation – whatever that level turns out to be. One fund manager who is well aware of this is Neil Woodford of Invesco Perpetual who has a long-term track record of outperformance. In an interview last week, Mr Woodford gave an insight into his current strategy.
“At a macro level my views are well known. We are experiencing a ‘balance sheet’ recession which has rippled out into the economy, resulting in both consumers and governments rebuilding their balance sheets and this process will last for a number of years. In the short term there has been much excitement around industrial production growth but this is outstripping sales which implies to me re-stocking. I think the outlook remains gloomy.
“Against this backdrop equities are attractively priced relative to other assets. There is a subset of shares that are very cheap. They are quality companies that have navigated their way through recession and continued to grow their earnings and profits. But this has not been priced in; in fact, these companies continue to be priced for decline. This presents a huge opportunity to capture this value from a small group of very dependable businesses so my portfolio today is, based on history, very concentrated at around 57 stocks. The core comprises companies like AstraZeneca, Glaxo, Tesco and other quality blue-chips, many of whom yield in excess of 5%. Rolls-Royce is another and I used the recent price weakness following problems with some of their engines to buy more: it is a world-class business and continues to win orders. Tobacco and utility stocks remain key core components too.
“I understand the excitement over emerging markets and I’m positive longer term, but today the opportunities are not as good as presented. The interesting aspect is that many of the companies I own do have significant indirect exposure to the emerging markets. Take Imperial Tobacco – its business is heavily focused towards Brazil and India. AstraZeneca is the second-largest pharmaceutical company in China and one third of Tesco’s earnings now originate from abroad. Overall, the portfolio, when measured by earnings, has less than a 25% exposure to the UK economy: the rest is overseas. It is a proven fact that it is cheaper to buy emerging market growth via developed economy companies and of course it comes without the currency risk. So today I have the portfolio I want. The large positions reflect my conviction about the state of extreme undervaluation and I’m very positive about the opportunities ahead.”