In this week’s bulletin:
The clamour over inflationary threats once again dominated markets last week – along with ongoing geopolitical concerns and the eurozone sovereign debt issue.
- Whilst central banks in the developed markets are resisting the pressure to raise interest rates, government bond investors are exerting pressures, causing yields to rise. Last week the BoE announced it was leaving rates unchanged despite CPI rising to 4%.
- One clear theme is a move by investors to reduce their exposure to Emerging Markets as concerns over monetary tightening grow and to favour developed equities over government bonds.
- More positive news on US unemployment and the departure of Egypt’s President Mubarak gave markets a late fillip, enabling Western bourses once more to trade around 2 and a half-year highs.
- Equity Income fund manager Nick Purves of RWC explains how his approach can deliver prospects of both a rising income and capital growth.
Blowing Hot and Cold
Inflation is proving to be a thorny issue for both consumers and economists alike. Last week was no exception, with a continuing flow of data highlighting rising costs and prices – with more to come it seems. In a recent speech, Mervyn King, Governor of the Bank of England (BoE), warned that UK inflation could spike to 5% before falling back: the Bank’s argument is predicated on the belief that a number of one-off factors – such as the VAT increase – will ultimately drop out of the numbers. This week, economists are of the view that the Consumer Price Index (CPI) will jump to 4% when figures are released tomorrow. “Petrol prices rose 5.1% in January – that alone is enough to push CPI 0.1% higher. The price of food and heating oil also increased. The VAT rise will also be crucial,” was the view of Société Générale. There was similar news from the Office for National Statistics, which said that factory price inflation had risen twice as quickly as forecast last month, with producer prices up 4.8% – a direct result of soaring energy and metal costs.
The causes of higher commodity prices are self-evident – rising demand in emerging and developing economies is being fuelled by rapid economic development as countries like China pump billions into building their infrastructure, added to the impact of a burgeoning number of middle-class consumers. Last year, China used more concrete that the US, UK, Germany and France combined as it pressed ahead with its breakneck pace of growth. This demand is in turn pushing up the cost of raw materials including soft commodities. Not that everyone is a loser of course – last week mining company Rio Tinto announced that it had reduced its debt pile by £21.5bn in just two years thanks to very strong price increases for iron ore. So successful has it been that it is buying back some $5bn of shares. The numbers get bigger. BHP Billiton is set to reveal profits of more than $15bn this week, putting the resources company on track to generate one of the largest ever profits by a UK company in a single year, thanks to the commodities boom.
Borrowing Costs Edge Up
The ramifications of higher inflation could be far-reaching. Robert Smithson of THS Partners, which manages funds for St. James’s Place, commented, “We expect higher inflation globally over the next few years and for interest rates to rise in response, albeit at a slow pace. Equities are, on the whole, likely to fare better than other assets, as companies are usually able to pass rising costs down to their customers, thereby protecting profitability. One of our themes – Changing Diets – has led us to invest in companies that will benefit from increased food prices and higher calorie consumption in the emerging world, for example Bungey and Yum Brands. Our Deep Value Opportunities theme centres around us owning a number of insurance companies, such as Allianz and Aegon, which stand to benefit significantly from higher inflation and rising long-term interest rates.”
The point about rising interest rates as a tool to combat inflation is particularly pertinent. Last week a number of UK mortgage lenders rushed to pull their best fixed-rate deals and replace them with those bearing higher rates. In the government bond (essentially IOUs) market, the yields on longer-dated paper have been rising – including in the UK gilt market as investors begin to price in higher interest rates. For yields to rise it means capital values have to fall and this is having a knock-on effect for the BoE which, according to The Times, is at risk of recording billions of pounds of losses on its money-printing quantitative easing (QE) scheme. QE was introduced almost two years ago to help boost recovery and involved the Bank buying up gilts with its new money to keep interest rates low. It now owns £200bn of gilts and whereas the scheme was in profit to the tune of £26bn last August, this figure has fallen to £10bn as gilt prices have retreated in recent weeks. Higher interest rates would therefore exacerbate the situation. Coincidentally, the BoE’s Monetary Policy Committee met last week to review its interest rate policy and, in the face of a worsening inflation outlook, held its nerve and decided to keep rates on hold. The decision came as no surprise to the 62 economists polled by Bloomberg who all expected this outcome.
Full of Import
The emerging markets’ remarkable growth boom has created an interesting and yet delicately balanced dichotomy. On the one hand it creates huge opportunity for the developed economies to export more of their goods to the likes of India, Russia and China but, on the other hand, as mentioned previously, the flipside consequences are higher and inflationary raw material costs. And for the UK, therein lies the problem it seems. Economist David Smith, writing in The Sunday Times, mulled over the fact that whilst Britain’s companies are exporting more – goods and services have risen more than 10% in the past year – unfortunately Britain’s importers have also been working overtime: imports have grown 14.5% over the same period. As Mr Smith points out, it’s impossible to have true, export-led growth if that growth is exceeded by imports. As ever, it’s cause and effect – specifically the 25% devaluation of sterling during the financial crisis which has helped make exporters more competitive but also pushed up the cost of raw material et al. Helping things along are the UK’s consumers who proved they are still capable of spending – retail sales jumped 4.2% last month as Britons flocked to the high street, snapping up non-food items such as clothing and electronic goods. So, for now, it looks like we’ll just keep on running an ever-growing trade deficit.
Meanwhile . . .
. . . over in the financial markets, investors endured a choppy week. Disappointing corporate earnings, renewed tensions over eurozone sovereign debt and mounting confusion over the situation in Egypt ensured some volatile trading. Lower-than-expected earnings figures from the likes of Cisco Systems and Credit Suisse rattled investors, sending shares into retreat, with those in emerging markets faring worse as growing inflationary fears raised worries about monetary policy (interest rates) tightening. Last week, China increased its benchmark interest rate by 0.25%, the third move since October. Over in the eurozone there were suspicions that the European Central Bank had intervened heavily to support Portugal’s bond market following revived fears that the country might be forced to seek international financial aid. An economist at ICAP said, “It would appear, at face value, that the ECB is back in, buying aggressively.”
Investors took heart from comments made by US Federal Reserve Chairman, Ben Bernanke, who gave a slightly more optimistic assessment of the US jobs market, although he did warn that unemployment remained too high for comfort. During the week, data released showed that new claims for jobless benefits in the US dropped to a 30-month low, suggesting a strengthening labour market. The US Labor Department said initial claims fell 36,000. A welcome end-of-week boost came in the form of Friday’s news that Hosni Mubarak, Egypt’s president, had finally stepped down, which enabled equity markets to shake off earlier losses and rally sharply. So, on balance, the week reflected a shift in sentiment away from emerging market stocks and into developed market equities, together with increased wariness over inflation. The Financial Times summed up when commenting that with inflation now also a concern for some (developed market) central banks, it is not surprising that markets are choosing the inflation hedge of equities as opposed to the nominal returns on offer from bonds. By close of business on Friday the Frankfurt Dax Index topped the leaderboard, up over 2%, followed by Wall Street and London – heading south were the Hang Seng and Bombay Sensex indices.
One well-tried and tested strategy to combat the threats of inflation has been to invest in equity income funds which offer the opportunity of a growing income via rising dividends. The Sunday Times reminded its readers that over the long term equities have performed better than cash and gilts after adjusting for inflation. In its latest review of the performance of UK shares and bonds, the just-released Barclays Equity Gilt Study showed that over the 30 years to 2010, UK equities returned 8.3% a year after inflation. Within these figures, of course, some sectors do better than others, as figures from the London Business School highlight. For example, £1 invested in the UK stock market in 1900 would have grown to £23,335 but the same pound invested in the 50 shares with the highest yield (the ‘value stocks’) would have grown to an impressive £100,160.
One of the UK’s leading equity income managers, Nick Purves of RWC, which manages funds for St. James’s Place, explains his approach. “High-yielding stocks are by definition lowly valued – sometimes for good reason but often because the market has overlooked them. I concentrate on finding good quality companies that are essentially sound with strong balance sheets, but are seen as unfashionable. The next step is to be patient – it can be a slow process waiting for the fundamentals to be recognised but when they are, a value stock can become a growth stock. So the portfolio currently has 30 stocks with solid dividend yields which are covered by earnings several times over, which makes them less risky. I think the outlook for income is very positive at present, with many companies increasing dividends at a faster rate than could have been hoped for a year or so ago, so I feel confident about the prospects for my income investors.”
Time is Ticking Away
As we approach the end of the tax year, investors are being reminded not to waste valuable tax breaks – from Individual Savings Accounts to pension contributions. The latter took pole position with The Daily Telegraph as it told its readers that there are only six weeks left before the new pension reforms kick in. These will see significant reductions of the pension contribution allowance as well as likely cuts to income under the drawdown rule changes. The paper recommended that if you’re unsure as to whether you will be affected then seeking advice is an imperative.
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