In this week’s bulletin:
- Global equity markets enjoyed one of their best weekly rallies in over two years last week with most major indices up around 7%. The gains followed two weeks of losses and came after a group of the world’s Central Banks announced a concerted package of help to increase liquidity for European banks.
- Up until Wednesday, the cost of borrowing dollars to fund liabilities had become excessively onerous for European financial institutions and increasingly they were relying on the European Central Bank as a source of borrowing. To counteract this freezing of liquidity the US Federal Reserve announced it was cutting the rate at which it lent dollars to the ECB by 0.5% which would mean the Bank could then lend at lower rates to European banks.
- At the same time China announced that it had reduced the level of reserves banks needed to keep available – partly down to a belief that Beijing had finally controlled inflation and partly down to concerns about slowing global growth.
- In the eurozone, finance ministers agreed to guarantee up to 30% of the value of new bonds issued by problem members thus effectively boosting the available size of the eurozone bail-out fund. Along side this the market sensed that finally a workable plan was evolving to address the eurozone crisis and most likely include German wishes for closer fiscal unity for the 17 eurozone members. Angela Merkel made clear her determination to keep the euro and introduce Treaty changes to bring about greater fiscal rectitude.
- Whilst eurozone policymakers may have been in turmoil, European companies have been quietly going about their business, boosting their balance sheets and growing their order books – SW Mitchell explain what is happening down on the ground in corporate Europe.
- We explain how investors can implement a successful strategy to combat volatile markets.
Christmas arrived early last week for global financial markets as they staged one of their largest rallies for over two years, on the back of a concerted move by a group of the world’s central banks to avoid a re-run of a Lehman-style crisis. Following nine days of consecutive declines, as investors became ever more fearful that the eurozone crisis would cause global growth to implode, equity markets started the week in better form. Confidence grew too on the back of better-than-expected economic data from the US, which has proven remarkably resilient to Europe’s woes. Latest official data showed manufacturing improving, US consumers feeling more confident and, to cap off the week, better employment figures. US non-farm payrolls rose by 120,000 in November and there was a surprise, but welcome, drop in the unemployment rate from 9% to 8.6%. And here in the UK, even a downbeat assessment of the economy and news of increased government borrowing failed to dampen spirits. So by the end of the week most major equity indices had notched up substantial gains of around 7% as investors decided that the economic and financial outlook had improved.
Central Banks ‘Bazooka’
The much-vaunted big ‘bazooka’ so long expected of Europe’s policymakers turned up unexpectedly last week and from an equally unexpected source: world central banks. Up until Wednesday morning, shortly before the announcement of a co-ordinated move to flood the system with dollars, the premium that banks had to pay to convert their euros into dollars shot higher to a level not seen since October 2008, a month after the collapse of Lehman Brothers. Known as the ‘euro-dollar basis swap’, the figure is a closely watched indicator of stress in the banking sector and having reached 1.6% (more usually the spread is around 0.5%) it was flashing on ‘Danger’.
European lenders need to be able to source dollars and other types of funding to help finance hefty liabilities that are denominated in the US currency. However, US money market funds, traditionally a major source of dollar funding, have over recent months been trimming their lending to Europe’s banks as they became ever wary of the escalating credit risk.
In essence, a breakdown of trust between the banks themselves and the likes of money market funds meant Europe’s banks faced a significant risk of a financing freeze, with all the ramifications for the eurozone economy. Faced with this dilemma, banks have increasingly turned to the European Central Bank (ECB) as a source of borrowing – just over a week ago, lending by the ECB rose to its highest level this year, some €8.4bn, triggering alarm bells. Traders took the view that the jump in overnight lending highlighted the inability of virtually all eurozone banks, with the exception of the very strongest, to obtain funding from the markets. Against this backdrop of elevated ECB lending and rising premiums or spreads for borrowers, some of the world’s central banks, including the ECB, US Federal Reserve, Bank of Japan, the central banks of Switzerland and Canada and the Bank of England, announced a huge increase in liquidity. Leading the way, the Fed slashed the rate it charges the ECB for short-term dollar loans from about 1.1% to 0.6%. This would enable the ECB in turn to provide cheaper dollar loans, via swaps, to European commercial banks.
The six central banks involved also agreed to create temporary bilateral swap programmes so funding can be provided in any of the currencies if needed. The new pricing arrangements start today and will remain in place until February 2013. Also, as part of the deal, the ECB is widely expected to offer Europe’s banks two-year or three-year loans to ease financing pressures and it could also accept more types of collateral in return for its loans. Alongside the announcement, the Federal Reserve said US financial companies do not currently have difficulty in obtaining liquidity in short-term funding markets. It also added, pre-emptively, that were conditions to deteriorate, it had a range of tools available to provide an effective liquidity backstop for such institutions.
Two hours before the Fed announcement, China cut the amount of cash that the nation’s banks must set aside as reserves, for the first time since 2008. The level for the largest lenders was cut by 0.5% from a record 21.5%, based on past statements. The move by Beijing was interpreted that it finally believed it has beaten stubbornly high inflation and also indicated the degree to which it has become concerned about a slowdown in the world’s second-largest economy.
All For One…
Whilst the central banks’ dawn raid was well received by the markets, it is not of course a solution to the ongoing problems in the eurozone which still remain: too much sovereign debt, slowing economic growth and some of its members being insolvent. However, confidence has been growing that European policymakers are a step closer to finding a workable solution that will satisfy the markets. To date, market opinion has vacillated between the likelihood of a break-up of the eurozone, which would have serious ramifications for everyone, and the chances of a longer-term remedy involving some form of fiscal integration for the region’s 17 member states. In the interim, the ECB has come under huge pressure to act as ‘buyer of last resort’ for the bond market (despite this not being in its remit) and German intransigence is seen as being responsible for this failure to act decisively. In a speech last week, Poland’s foreign minister, Radoslaw Sikorski, said that Berlin should admit that it is the biggest beneficiary of current arrangements (that is, an undervalued currency relative to its own if it were outside the euro and ultra-low borrowing costs) and that therefore it has the greatest obligation to make them sustainable.
It is though becoming increasingly clear that Germany does have a plan and that it is determined to keep the eurozone intact. This week, Angela Merkel will hold a series of meetings with European leaders, including President Nicolas Sarkozy, as she presses forward with her plans to create a legally enforceable ‘fiscal union’ to restore confidence in the eurozone. Last week, the German chancellor insisted she would defend the euro and that her aim was to persuade her EU partners to negotiate swift treaty change to enforce budget discipline and debt control in the eurozone. Market sentiment in the embattled bond markets of Italy and Spain has improved as the outline of a package emerges. European finance ministers took the opportunity to announce, alongside the central banks’ decision to boost liquidity, they had agreed to guarantee as much as 30% of new bond sales from troubled governments to enhance the region’s bailout fund and to improve its ability to cap yields by buying bonds. The next few days are seen as crucial for the eurozone in the run-up to the EU summit on 9 December, when it is widely expected ministers will announce a package of reforms to stabilise the region.
Last week, the chancellor announced in his Autumn Statement that forecasts for UK government borrowing have been increased. He said borrowing would be £5bn more this year than originally forecast, £19bn higher next year and £30bn higher in 2013–14. The increases are a result of the reduction in the expected level of growth in the economy. As a consequence, the Office for Budget Responsibility (OBR) now expects growth of 0.9% this year, down from the 1.7% predicted in March; and the prediction for next year has fallen to 0.7% from 2.5% predicted in March. The implications of this mean that the government will have to extend its planned austerity cuts for a further two years.
George Osborne said, “Our debt challenge is even greater than we thought because the boom was even bigger, the bust even deeper and the effects will last even longer.” As a consequence, the borrowing forecasts predict that the government will borrow £111bn more in the next five years than had been expected in March. However, the chancellor stressed that the current forecasts did not predict a recession, but added that the OBR was assuming “that the euro area finds a way through the current crisis and that policymakers eventually find a solution that delivers sovereign debt sustainability. If they do not then the OBR warn that there could be a much worse outcome for Britain. We hope this can be averted, but if the rest of Europe heads into recession it may prove hard to avoid one here in the UK”. Despite the worse-than-expected borrowing numbers, the gilt market took the news in its stride, with yields on the ten-year benchmark bond staying around the 2.2% gross level.
Business As Usual
Eurozone worries have, unsurprisingly, dominated markets over the last few months, with investors being subjected to increased short-term volatility. Share prices have swung from positive to negative by quite large amounts as markets attempt to price in not only the downside risks but also the potential upside. The word in the City is that many market participants are just as worried about missing out on a potentially large rally should a deal be struck by the EU as they are about trying to avoid a possible setback. Notwithstanding the uncertainty, for one sector of the community it’s business as usual: and that’s the corporate world. Fund managers S. W. Mitchell Capital specialise in European stocks, and as part of their due diligence visit over 400 companies every year, and so are well placed to gauge sentiment.
“Unlike many governments, post-credit crunch, the corporate world has taken matters into their own hands. Businesses have cut costs, improved margins and many have built up significant cash on balance sheet. Currently, one-third of Europe’s market capitalisation is covered by cash which means the health of companies is very good.
“We are concentrating on high-quality franchises. Some of the companies we own are looking for high turnover based on exposure to emerging markets, which continues to be a good source of growth. We own Swatch which has managed to capture not only the high-value, brand niche but also the mass market end too. If things do slow then margins are unlikely to suffer much and like many of the companies we own, has a strong balance sheet and reasonably assured growth which they can turn into profit and from a value perspective, is astonishingly cheap. Although we are not an income investor per se, the portfolio yields around 3.5% and dividends are well covered. In the short term though, being a value investor and stock picker hasn’t really worked too well because of high levels of correlation in the markets – it’s either ‘risk-on’ or ‘risk-off’ – with investors caught in the headlights. However, one just needs to be patient as markets are trading at extraordinarily low multiples, which means there is currently significant intrinsic value in many shares, which means opportunity for gain. Given the current uncertainty surrounding the future of the eurozone, we are finding that companies are carrying on as usual: manufacturing products and selling them to their customers at a profit.”
During periods of uncertainty and market volatility some investors are understandably nervous about committing funds in a single transaction. However, one investment strategy that we have found to work particularly well during this type of environment is that of phased investment. This approach has a number of benefits: the investment is initially held in a cash fund and then is gradually phased into the markets – be they equity, fixed-interest or property – over a predetermined period of time. This helps ‘smooth’ the entry costs, with multiple investments being made at different prices – sometimes known as ‘pound cost averaging’. The end result is that an investor can achieve their medium-to-long-term objectives without having to worry about short-term market movements and having to make ‘market timing’ judgements.