In this week’s bulletin:
- The eurozone bond market was once again ravaged by investors last week who turned their attention to Spain and France. Yields on Spanish bonds came perilously close to the 7% ‘danger’ level at which economists believe it would be impossible to financially sustain.
- With all eyes focused on Spain and the outcome of its imminent general election, investors chose to ignore better economic data from both the eurozone and more crucially, the US. In the UK unemployment worsened in the third quarter with some 2.62m unemployed.
- However a small fall in the UK CPI figure was heralded by many as a key indicator that inflation had peaked in September and is now set to fall back within the Bank of England’s 2% during 2012. However not all agree and even the BoE itself cautioned that the outlook remained uncertain.
- As expected, the Popular Party trounced the opposition in yesterday’s Spanish election which means that Mariano Rajoy will become the country’s new leader. Last week Mr Rajoy pleaded with the financial markets to grant new governments “more than half an hour” in which to turn round their economies.
- Expectations about lower inflation may or may not be realised but either way, savers are still currently guaranteed a negative real return on their cash which has caused many to review their current strategy. We discuss the choices currently available to investors.
It was more of the same for the eurozone bond markets last week as investors kept up the pressure on the region’s politicians to implement the next stage of their ‘grand plan’. Even with new ‘eurocrat’ governments installed in Greece and Italy, bond vigilantes gave no respite: eurozone bond markets plumbed new depths in the crisis last week as intensifying contagion sucked in Spain and France. Escalating fears over Europe’s debt problems were exacerbated by its policymakers, who continued to squabble in public over the role that the European Central Bank (ECB) should play.
Many of Europe’s leaders believe the only way to resolve the crisis is for the ECB to act as ‘lender of last resort’ by printing sufficient money to buy up as many government bonds as it needs to. The problem is that the central bank has no mandate to take such action (although it has selectively been buying peripheral government bonds), even if Germany allowed it to, which currently it won’t. German Chancellor Angela Merkel made it quite clear last week that such a course of action is untenable and not up for discussion. So in the meantime, poorly received auctions of Spanish and French debt set the scene for a tug-of-war struggle between the markets and the ECB, as yields rose towards the 7% ‘danger’ level. From the sidelines, Bank of England Governor Sir Mervyn King accused world leaders of piling the pressure on the ECB to save the eurozone instead of “owning up” to their responsibilities to stop the crisis, adding that it is not the job of a central bank to bail-out stricken economies.
Europe’s bickering unfortunately overshadowed positive signs of a brighter economic outlook in the US and also better-than-expected growth from the eurozone itself. During the third quarter the eurozone economy did not fall back into recession but managed to grow, albeit a modest 0.2%. However, within the figure, was evidence that growth in the region’s two largest economies – France and Germany – had rebounded but even this failed to cheer the markets. Official US data showed that consumer spending rose by a surprisingly healthy 0.5% last month; much better than market expectations, as was data indicating that manufacturing is rising at its fastest pace in three months. Unemployment claims fell back too, indicating improving business confidence as employers hired labour in the run-up to Christmas.
Unfortunately, UK unemployment numbers were not so positive, as official figures from the Office for National Statistics (ONS) showed that total unemployment rose to 2.62m in the three months to September. Most worrying was the fact that youth unemployment passed 1m for the first time since records began 20 years ago. So against this backdrop it was no surprise that global equity markets gave ground, with the FTSE All World index slipping almost 4% on the week as investors moved to the sidelines or opted for the perceived safety of bunds, Treasuries and gilts.
With Spain in the firing-line of the bond markets last week, the country’s general election – held yesterday – piled the pressure on the victor. Conservatives in Spain are celebrating a landslide victory in today’s national elections. Spain’s centre-right Popular Party (PP) has won a resounding victory in a parliamentary election dominated by the country’s deep debt crisis. With almost all the votes counted, the PP, led by Mariano Rajoy, is assured of a clear majority in the lower chamber. The Socialist Party, which has governed Spain since 2004, has admitted defeat. Mr Rajoy, who is expected to tackle the country’s debts amid slow growth and high unemployment, said he was aware of the “magnitude of the task ahead”. He told supporters there would be “no miracle” to restore Spain to financial health, and that the country must unite to win back respect in Europe.
Last week Mariano Rajoy, in anticipation of winning, pleaded with financial markets to grant new governments “more than half an hour” in which to turn round their economies. With Spanish bonds being pummelled, Mr. Rajoy said “I hope this stops . . . [and the markets] realise that there are elections and that the winners must be given a little room for manoeuvre that should last more than half an hour”. Mr. Rajoy’s task will not be easy; Spain is struggling with 5m unemployed – some 21% of the workforce – and recorded zero growth in the third quarter. Also, imposing policies from the centre of a national government doesn’t necessarily mean they will be implemented: the country’s political regions are effectively autonomous and many are heavily indebted. However, in his favour, Mr Rajoy has overwhelming support from Spanish business leaders. Spain’s tourism businesses and its industrial exporters are robust and their successes have helped cut the country’s current account deficit from 10% of GDP to under 4% over the last four years. Despite its struggling construction-heavy domestic economy, the country has maintained its share of world exports since 1999. All Mr Rajoy has to do now is to engineer economic adjustment to the satisfaction of two very different constituencies: the Spanish people and the international bond markets.
An Inflated Outlook
Here in the UK, it was inflation that captured attention: probably more than the headline figure justified at first glance. According to the latest data from the ONS, the annual increase in the consumer price index (CPI) fell from its September peak of 5.2% to 5% in October. Falling petrol, food and air travel costs helped push down the overall rate of inflation. A major part of the fall was attributed to lower food costs which fell 0.9%, according to the ONS, who said this was “due to significant and widespread discounting by supermarkets and good harvests for certain produce”. Whilst the fall was small, many economists see this as the pivotal point, with inflation set to fall steeply over the coming months, a view held by the BoE and illustrated in the chart below, taken from its November Inflation Report.
CPI inflation projection based on market interest rate expectations and $275 billion asset purchases
Source: Bank of England Inflation Report
In its report, the Bank argued that inflation is likely to fall sharply next year as the contributions of VAT, energy and import prices decline. Its expectation is that inflation will then be back within its 2% target, which has been exceeded by at least 1% every month since January 2010. Indeed, not everyone is convinced that the Bank’s forecast will be anymore reliable than previous projections which it has failed to meet. By its own admission, the BoE comments that “How far and how fast inflation is likely to fall remain uncertain” adding that it will be influenced by the degree of slack in the economy, by companies attempting to restore their profit margins by raising prices and movements in commodity and other import prices. A closer look at the latest data shows that “core” inflation (which strips out volatile food and energy prices) rose from 3.3% to 3.4% as retailers pushed through price increases on clothing. Other technical changes such as tuition fees, will automatically increase CPI in the year ahead. So whilst any evidence of inflation falling is welcome, it is probably too soon to be certain that the worst is over.
Take Precautionary Action
The implications for investing are clear though, irrespective of whether the inflationary effects of higher commodity prices et al are short-term or whether inflation is making a longer-term comeback. It is worth remembering that long-run inflation in the UK is 2.8% [source: Barclays Capital] which means that any investment return needs to be adjusted for inflation to calculate the ‘real’ return. Today, interest rates are ultra-low and likely to remain so for the foreseeable future, so once cash returns are netted-down for tax and then adjusted for inflation, savers are guaranteed a negative real return. Of course, it doesn’t follow that one shouldn’t hold cash but what it does mean is that many investors have been reviewing their cash positions and deciding to go ‘underweight’ in their search for better returns, albeit with a higher degree of risk.
Whilst we have discussed the merits of other classes available to investors previously, it is worth recapping. From a risk perspective, fixed-interest securities sit above cash and include the likes of government bonds (gilts and sovereign bonds) and corporate bonds, all of which are graded according to the quality of the issuer. The principle is simple: investors are promised their money back upon maturity and paid an income, or coupon, during the term. Historically, because of their fixed nature, bonds do less well during periods of elevated inflation, although the reverse would be true if inflation does fall and currently it is possible to invest in a quality portfolio of corporate bonds that yield 5.6% gross.
Commercial property is another asset class that offers investors the opportunity of strong and consistent income as the chart below illustrates.
Source: Orchard Street: IPD Annual Index (Full history)
Commercial property expert John Humberstone of Orchard Street Investment Management gives his view on the case for property. “This asset class offers stable income return with potential for capital growth; it offers a high income return relative to other asset classes and historically has been a good inflation hedge. The commercial property market looks very attractive at present, especially when compared to the benchmark gilt yield, with the market currently yielding around 6.4% gross. From our perspective, we believe that there will be some compelling investment opportunities as a result of sell side over-supply, by which I mean more foreclosures by lenders in the coming months. And crucially, the majority of forecast total return is from the rental income which is not reliant on investment market movement”.
The last asset class to consider are shares. Equities are usually a good hedge against inflation because many companies – particularly those with strong brands – have pricing power, that is, they are able to push through price increase in line with inflation. Over very long periods, equities have demonstrated that they have been one of the best forms of protection against the ravages of inflation. Currently, many investors are seeking out high quality blue-chip companies which have a good track record of increasing dividends and recent data has been promising. 200 UK companies reported dividends between 20th July and 30 Sept, of those 155 increased dividends, 34 left them unchanged and 11 reduced their payment. Of the 11 reductions, eight were not real declines but rather because dividends were announced in dollars so UK investors lost out on the exchange rate So, just 3 out of 200 companies reduced their dividend over that time period. The average growth across the 155 increased payments was 26.5%, significantly above the rate of inflation and whilst not guaranteed it does give an indication as to the prospects from this type of investment.
(Source: Schroders 25 October 2011)