In this week’s bulletin:
- Investors’ went from ‘risk-on’ to risk-off’ last week as the positive earnings outlook and success of the eurozone bail-out fund’s bond debut were replaced by economic and geopolitical concerns.
- Mid-week markets were shocked by news that Britain’s economy had shrunk by 0.5% in the final quarter of 2010 although the impact was muted by the view that most of this was down to December’s poor weather and growth would rebound.
- In contrast the latest data showed the US economy powering ahead in 2010 as consumers and businesses benefitted from President Obama’s economic stimulus.
- Worries about America’s burgeoning budget deficit were placed on the back-burner unlike in Japan where the country’s credit-rating was down –graded to AA- by S&P in response to worries over current debt levels.
- Investor worries over a possible bond market ‘bubble’ are discussed by Paul Read of Invesco Perpetual
- The Financial Times told its readers that with returns from with-profit bonds less than many cash accounts investors might think about taking advantage of any penalty-free exit opportunities available.
Market strategists have had a full-time job over the last year trying to gauge the best course of action as investors’ mood vacillated, but finally came up with the ‘risk-on, risk-off’ solution. Early on, it was risk-on, with US and European stocks pushing back towards recent two-and-a-half-year highs: the FTSE 100 flirted with the 6,000 level once more with investors buoyed by the corporate earnings outlook. “One of the more compelling reasons for us still being in the risk-on part of the cycle remains the still-strong earnings backdrop,” was the view of Deutsche Bank. The mood was not quite so positive in emerging markets, though, with political concerns unsettling Bangkok and Moscow and leading some strategists to take the view that emerging markets stocks were beginning to look expensive. “Tightening monetary conditions in emerging markets should lead investors to rotate away in favour of developed market assets,” thought Lombard Odier.
But, as The Financial Times noted, the risk-off button was soon pressed with news that the UK’s output went into reverse in the last quarter of 2010, coupled with investor disappointment at the latest batch of US corporate earnings and caution about the US Federal Reserve’s latest meeting. The scene was set following news of a 0.5% contraction in Britain’s economy – a genuine shock to most economists – although some comfort was taken from the view expressed by the Office for National Statistics that much of the drop was linked to December’s appalling weather. Even so, the ONS said that the overall picture looked “flattish”, although few believe there is any danger in the economy going back into recession. With household incomes under pressure from rising inflation and no real wage growth, the Governor of the Bank of England, Mervyn King, defended the Monetary Policy Committee’s (MPC) decision not to raise interest rates in the face of rising prices.
The Governor went on to say that real (inflation-adjusted) wages were unlikely to be any higher than they were back in 2005. Economists are hoping that, against a backdrop of planned government expenditure cuts, the private sector will take up the slack to keep the economic recovery on track. The ONS figures were mixed on this front, with construction falling once more and slippage in the service sectors. The one bright spot was a robust effort on the part of manufacturing as exports rose strongly, helped by the relative weakness of sterling. The discussion about the impact of higher inflation and whether the BoE should raise interest rates continued last week and, whilst expectations of higher rates over the next six months or so are now higher than a few weeks ago, it is not clear-cut. Coming out strongly against more costly borrowing was economist Roger Bootle who said there was no real evidence that the gilt market is getting alarmed – ten-year bond yields remained little-changed. Mr Bootle argued that any rise in rates now would imply the BoE had been wrong so far and also set expectations that the rate cycle had changed.
Spend or Save?
With many European governments having embarked on a huge programme of austerity cuts, the US has been resisting pressures to do likewise, with the Obama administration insisting that this is not the time to save but to spend more to engender a strong economic recovery. In the short term, Mr Obama’s decision to put expenditure cuts on the back-burner has been vindicated. Figures out last week showed that the American economy powered ahead at the end of last year as the US continued to spend its way out of recession, with government stimulus money helping create a surge in consumer spending. US economic growth advanced to 3.2%, according to official figures, as Americans spent at the fastest pace in four years and companies sold more goods and services overseas. But the current administration’s reluctance to put together a long-term strategy for cutting the massive budget deficit – it’s set to hit a record $1.5 trillion or 9.8% of GDP this year, according to credit-rating agency Moody’s – is worrying many observers, including the IMF. Whilst many recognise the need to make savings, there are some who are cool on cutting the deficit; mainly US businesses, said The Financial Times. American bosses are worried that they could end up footing the bill when it comes to redressing the country’s public finances. Government spending cuts would hit private sector profits and tax reforms would likely cut corporate tax breaks currently enjoyed.
Against this outlook, Moody’s did say that it might have to downgrade America’s premier AAA rating if no plan was forthcoming: although, for now, international investors are not worrying unduly; and this is reflected in the ten-year Treasury bond yield, which remains close to recent lows. Not that the same could be said of Japan. Last week the country’s long-term sovereign debt rating was cut by Standard & Poor’s for the first time since 2002. The cut from AA to AA- reflects increasing investors’ concerns about events in what was, until recently, the world’s second-largest economy.
Fund manager Dan O’Keefe of US-based Artisan Investment Management summed up the consensus view, saying, “Like many developed countries, Japan is in a perilous fiscal position, running large deficits with significant debt relative to GDP. It stands out however for the inability of both its government and corporate sector to mount any meaningful response to the economic challenges they have long faced. As a result, we have always found it very difficult to find attractive investments in Japan. So, while it is easy to find cheap stocks, rarely do we find true value, hence our small portfolio weighting. We have been especially cautious of late as we believe that the recent strength of the Japanese yen is not justified given the structural issues mentioned. The downgrade by S&P certainly brings the issues of Japan into clearer focus but it does not reveal anything new.”
As the week drew to a close there was one final twist for investors to think about: the resurgence of geopolitics in the form of political unrest in Egypt. With the escalating unrest in the region’s anchor state, it was no surprise that some investors sought their usual flight into bonds and gold as a short-term haven; but it also caused Brent oil prices to rise within a whisker of $100 a barrel too. Analysts were quick to comment that some had underpriced the risks of emerging markets, saying that whilst it was right to focus on the improving fundamentals of developing countries, politics mattered, particularly in sovereign states with unstable systems. So it was no surprise that the heady mix of economic, corporate and political news meant that global markets endured a choppy week, although in some respects the final outcome was perhaps surprising. Japan ended the week up, Shanghai rose to prevail over a falling Hong Kong market and the Bombay Sensex fell over 3% as the market reacted to higher Indian interest rates. Strong demand for the eurozone bail-out fund’s debut bond issue – it was ten times oversubscribed – eased concerns about the region’s periphery and in turn acted as a support for equity markets. Wall Street and London may have seen earlier gains reversed but both stock exchanges ended the week little-changed.
Investing for Income
One asset class that has served those investors seeking income well over the years has been corporate bonds – effectively IOUs issued by companies. With all the talk of interest rate rises because of higher inflation, some investors have expressed concerns about the longer-term merits of owning what is primarily an income-producing investment. Paul Read of Invesco Perpetual is recognised as one of the sector’s most successful managers and co-manages two of the St. James’s Place corporate bond funds. Here he gives his view of the current environment. “There has been widespread discussion about the possibility of a ‘bubble’ in bond markets. Investors’ concerns over valuations stem principally from the low level of government bond yields that reflect the extremity of the current economic cycle. However, we believe that both the policy and low yields are appropriate for the circumstances we face.
The central view of the MPC is that inflation will fall back as the impact of temporary factors wane. We agree that it is hard to be too bearish about inflation unless there is strong improvement in aggregate demand. With low growth and inflation expected to fall, we expect interest rates to be low for years. Given the characteristics of the fixed-interest asset class in which investors receive a fixed coupon [income] and return of principal, the main risk is of negative ‘real’ returns if inflation is persistently higher than the income received. Repricing is also a risk as market interest rates rise. Most investment-grade corporate bonds are issued by well-established blue-chip companies with strong balance sheets, low gearing and a history of low default. Global growth expectations are improving and the threat of deflation has receded – conditions that should see yields rise further. We therefore expect corporate bonds to outperform government bonds in this environment.”
Window of Opportunity?
One investment that regularly comes under the scrutiny of the personal finance press is that of with-profit bonds. The Financial Times drew its readers’ attention to the fact that investors in with-profit bonds should take advantage of opportunities to exit their investments without penalty as new figures (source: Money Management) show that the annual bonus rates on nearly 100 with-profit bonds are less competitive than returns on cash savings. The paper said this coincided with news that Friends Provident announced it was freezing most of its regular bonus rates in spite of improved returns. Figures show that 90% of with-profit bonds paid an average bonus rate last year of just 1%, although the article did say that not all funds are poor performers. Apparently there are a number of funds which this year will offer a penalty-free exit on the tenth policy anniversary.