In this week’s bulletin:
- Financial markets remained volatile last week – goods news from the US in the form of President Obama’s stimulus package was offset by renewed concerns in the eurozone following the resignation of Germany’s Jurgen Stark from the ECB
- Currency markets were stunned by the announcement from the Swiss National Bank that it had set a ceiling for its currency against the euro, arguing that the strength of its currency was pushing it into recession. Seen as a safe haven, the Swiss franc dropped 9% on the news.
- Current market uncertainty revolves, in large, to worries about the eurozone but also the slowdown in global growth, particularly in the US so the larger than expected stimulus plan from President Obama may well address some of these concerns. The key issue is that whilst the $447bn plan would undeniably boost the economy it is dependant in large part to agreement from the Republicans as to how it will be funded and this is not necessarily guaranteed.
- The issue of creditworthy governments borrowing to boost economic growth was discussed by the respected economist, Martin Wolfe, who argued that the US, UK and Germany should look to spend more now whilst at the same time implementing longer-term plans for deficit reduction.
- On the subject of the euro, Germany’s constitutional court’s decision to uphold government policy allowing financial support to other eurozone countries was well received and a boost for Angela Merkel and she reaffirmed her commitment to the euro, saying it would not fail. But the markets are still looking for a resolution to the entire eurozone sovereign debt issue and some believe countries should be allowed to exit if they choose – not allowed under the current rules. Economist Roger Bootle discusses the possibility of how this might work in practice and the potential benefits it might offer.
- British banks are to be re-organised under plans from the ICB requiring them to ring-fence their retail banking divisions from riskier investment banking arms.
- Nick Purves of RWC explains the current strategy for his UK Equity income fund and how investors are able to tap into high levels of income with prospects of capital growth too.
Financial markets remained volatile last week, buffeted by good and bad news alike, as investors endeavoured to price in more positive data from China versus deteriorating confidence in the eurozone. The larger than expected fiscal stimulus from President Obama to boost the US economy found itself squeezed in the middle as markets gave a surprisingly scant and dismissive response. After a shaky start to the week, global equity markets got back on the front foot, buoyed by a decision of Germany’s constitutional court to support the government’s bail-out of stricken eurozone countries. Whilst not unexpected, it raised hopes that the pending bail-out of Greece would be completed and that powers giving the European stability fund (EFSF) to buy sovereign bonds, recapitalise banks and issue ‘precautionary’ loans to eurozone members facing liquidity problems would bolster markets. With worries about the eurozone temporarily abating, traders turned their focus back onto economic fundamentals. Some better news from the eurozone showed that German industrial production had jumped 4% in July – well ahead of expectations – and the latest data from China showed imports increasing on the back of strong domestic demand.
But the eurozone crisis grabbed the headlines again on Friday on news that Jurgen Stark, a member of the European Central Bank’s executive board and its chief economist, was resigning for ‘personal reasons’. There was speculation that he had quit over a row about the ECB’s bond-buying strategy: the bank has been buying Italian and Spanish sovereign debt to restore confidence in the markets and reduce the borrowing costs for the two countries. Mr Stark, who has the support of other German policymakers, is opposed to the current policy. Coupled with comments from the ECB’s president, Jean-Claude Trichet, who signalled that the bank was about to make a strategic U-turn by cutting interest rates in the face of deteriorating global economic prospects, this was enough to send the euro tumbling. The currency markets had already been stunned earlier in the week when the Swiss National Bank (SNB) said it was setting a ceiling for the Swiss franc against the euro in a desperate attempt to prevent the strength of its currency pushing the country into recession. The Swiss franc has been a perceived haven in recent times and heavy buying has pushed up its value to a point where the SNB believed it was massively overvalued. The efficacy of such a move and the SNB’s resolve is likely to be tested in coming weeks.
The Way Ahead
So by the end of the week most of the major stock market indices had retreated as investors weighed up the outlook for the global economy, corporate profits and most crucially the effectiveness of politicians in tackling two key issues; resolving the eurozone debt crisis once and for all and how to stimulate economic growth in the West – particularly the US – whilst at the same time trying to bring government budget deficits back under control. To date, policymakers have been relying on loose monetary policies (ultra-low interest rates), quantitative easing (printing money) and stimulus packages to boost the economy. However, at the same time many governments have already embarked on austerity measures (with the US being the exception), relying on economic growth to help repair their balance sheets. Now that growth is slipping away the markets are expecting decisive action from policymakers to get growth back on track and quickly. Recent stock market volatility is less about corporate earnings – which are mostly robust – and the health of businesses but more about the lack of political direction and resolution of the key issues outlined above. It is worth spending some time looking at the choices available and possible outcomes.
Monetary Policy Committee Holds Firm
Here at home last week, the Bank of England held interest rates at their current rock-bottom rate of 0.5% – again no surprise given the comments made by the BoE’s governor, Mervyn King, a few weeks ago that ultra-low borrowing rates are likely to be with us for the next 18 months or so. The one aspect that did disappoint was no mention of a further round of QE (quantitative easing) – some observers had hoped that the current low growth environment in theUKwould cause the MPC to respond with new asset purchases. Others, such as the likes of theInstituteofDirectors, were also keen for the MPC to provide a boost for morale with more QE. So why no action? For every business group that would have cheered, there might have been economists and investors panicking that the MPC knew something they didn’t – that the prospects for the recovery were even worse than previously thought. That is what makes central bank surprises so risky. So for now Mr King prefers to maintain a softly, softly approach to change.
There’s another, more important, reason why the MPC probably held off. In his recent speeches and press conference appearances, Mervyn King has spoken at length about the difficult period of restructuring that lies ahead for the global economy, and the need for politicians to grapple with the consequences of years of imbalanced growth and excessive accumulation of debt (by consumers and governments). With record-low interest rates and emergency cash, he and his colleagues at the ECB think they have helped buy some time for those imbalances to be worked out. But central banks can’t make those challenges go away. And they certainly can’t magically summon a strong global recovery, by simply firing off another barrel-load of cash. There is a view that the MPC may go for more QE later in the year but, in doing so, they would need to be confident that the economy was truly heading downhill, and we were not simply looking at a prolonged period of disappointing growth. It is worth remembering that theUKeconomy is still growing, albeit slowly, and is likely to achieve a c.1.0% increase in GDP this year. Against this backdrop, George Osborne has maintained his resolve to stick to spending cuts, arguing that any U-turns will undermine confidence and send gilt yields higher as has happened in the eurozone periphery.
Obama Pledges to Boost US Economy
Last week President Obama announced plans to boost the US economy by proposing $447 billion in tax cuts and new spending – a much larger push by the White House to rekindle growth in the world’s largest economy. The plan includes a reduction in the Social Security payroll tax next year for workers to 3.1% (from the current 4.2%); an establishment of an infrastructure bank and some $80bn in spending on new building projects. Reflecting fears that a new global economic slowdown was under way US Treasury Secretary, Tim Geithner, urged politicians and central bankers to cast aside “political paralysis [and] misplaced fears about inflation and moral hazard”. Whilst the measures will, if implemented, undeniably boost the economy, there is one major stumbling block; the plan relies in large part on hopes of winning support from Republican lawmakers who control the House of Representatives. The Republicans recently forced Mr Obama’s hand in the debt-ceiling debacle to undertake cuts to theUSdeficit totalling $1,200bn so it is unclear how the President’s jobs plan will correlate to these separate negotiations and how they will be paid for.
The objection to issuing even more debt is understandable – the American electorate have made their dislike of this approach keenly felt. However there is one school of economists including Martin Wolf, who believe the markets are sending a clear message to governments to borrow and spend. He argues that so long as private and foreign sectors run huge surpluses some governments must find it easy to borrow and the only question is which ones? Yields on bonds issued by the US, the UK and Germany have all tumbled in recent weeks as investors around the world flock to buy them – in the case of the US and Germany yields on ten-year benchmark bonds are below 2.0% (fifty year lows). One of the arguments against government borrowing is that once it reaches a certain level (90% of GDP is text book) growth slows sharply but, counters Wolfe, if you take the UK, public debt was 260% in 1815 and the Industrial Revolution followed. What matters most he said is how borrowing is used. Mr Wolfe concluded that fiscal policy is not exhausted and the need is to combine the borrowing of cheap funds now with credible curbs on spending in the longer term. The problem is that as the Western consumer deleverages and too large a part of the world saves too much, the last thing needed is for creditworthy governments to slash their borrowings.
Euro ‘will not fail’
So promised Angela Merkel, German chancellor, last Wednesday as she welcomed the country’s constitutional court ruling as “absolutely confirming” her government’s policy of “solidarity with individual responsibility”. She went on to say thatGermanywould continue to demand drastic debt reduction from its eurozone partners in exchange for providing them with financial guarantees. This means that once additional powers for the EFSF are approved,Germanywill raise the scale of its financial guarantees from €123bn to €211bn. The extent of the markets’ power should not be underestimated and incurring its displeasure has, as we’ve seen in the last year, been very costly for the likes of Greece et al. Last week, Silvio Berlusconi’s government caved into pressure from the bond markets and European partners by announcing a last-minute U-turn to strengthenItaly’s proposed austerity package. But investors are still nervous about the resolve of governments to follow through their promises and matters, as said earlier, were not helped by the resignation of Mr Stark from the ECB last week, which highlighted a divide in the bank’s senior management team.Germany’s successor has been announced as Jorg Asmussen, its top international trouble-shooter in the financial crisis. The move is seen as a bid to reassure both financial markets and domestic opinion, shocked by last week’s sudden resignation.
The resolution of the current eurozone crisis is clearly an imperative yet judging market reactions in recent weeks it would appear that financial markets are not wholly convinced. So what are the other alternatives? Some investors still believe Greece will default, including veteran UKequity manager Neil Woodford who has long held the view that the country will renege on its debt but also that such a move “would probably be the biggest buy-signal ever for equity markets”. Is such a move likely? Well, there are members of the eurozone who believe that expulsion from the eurozone has to be the final penalty and that the region must return to the anchors of the eurozone. Writing in The Financial Times the Netherlands Prime Minister and Finance Minister argued that the rules – set out in the stability and growth pact – are still valid but all the participants must abide by them. They proposed independent supervision of compliance with budgetary rules coupled with tougher sanctions for those countries that infringe the rules, including preventive supervision. Ultimately, they said, countries that do not want to submit to such a regime can leave the eurozone. The problem today is that this choice is not part of the European Treaty.
What might the implications be if say Greece were to exit the eurozone? Economist Roger Bootle argues that any plans would involve extreme secrecy so that investors didn’t withdraw money from vulnerable countries’ banks as this could prompt a collapse and further crisis. He also said though that, whilst an exit might be messy, the notion that such difficulties will prevent a country leaving is absurd – the practicalities are that existing debt would be converted to the new domestic currency along with some sort of default. The new currency would almost certainly fall below the conversion rate (from the euro) on the exchanges, which is where much of the advantage would lie. At a stroke, it would be possible to lower the country’s price level compared to the rest of the eurozone and the outside world. Prices would rise but providing this was less than the devaluation then this could open up the possibility of escape through economic growth driven by net exports. This happened to the UK in 1992 after sterling’s major fall. For now though investors remain nervous, waiting for decisive action on the part of the authorities
Banks Face Re-Organisation
UK banks should ring-fence their retail banking divisions to protect them from riskier investment banking arms, a government-backed commission has announced today. The Independent Commission on Banking, led by Sir John Vickers, said it would “make it easier and less costly to resolve banks that get into trouble”. The ICB called for the changes to be implemented by the start of 2019. Chancellor George Osborne welcomed the “good” report and said he planned to stick to the timetable it recommended. The changes have been well-trailed but originally the timetable was shorter with the changes to be implemented by 2015.
A Fund Manager’s View
With volatility running at elevated levels many investors have, sensibly, taken little or no action in respect of their investments, leaving the more challenging day-to-day decisions to investment professionals. Nick Purves of RWC is a UKequity income manager with a value bias – seeking out fundamentally sound businesses which are, for whatever reason, out of favour with the broad market. “The portfolio continues to be defensively structured, with 31 stocks – all high quality companies that are profitable and well-run. When choosing stocks I look at the valuation and weigh up the risks but I do take a long-term view. Today, valuations are low, income yields are very attractive – the portfolio yields almost 5% (net of basic rate tax) and dividends look secure. The companies I own are mostly non-domestically facing – in other words they derive most of their earnings from overseas, including emerging markets.
“I have consciously chosen to invest in liquid stocks where I can buy and sell relatively easily. Generally liquidity in the markets is very low, especially if outside the top one hundred stocks. So for safety I own many blue-chips such as Vodafone, Glaxo, Unilver, BSkyB and Tesco. The latter is newly acquired following my exit from banking stocks. Investors will have made money out of these in my portfolio but I made a decision recently, because of changing fundamentals, that there were less risky ways of earning good returns on capital. I think the outlook for dividends is positive. I expect them to grow at the long-run rate of 4%-5% which should outpace inflation. I have been disappointed with the portfolio’s performance in recent weeks – it has for the most part gone down in line with the market which is surprising given the defensive nature of the companies I own. However, we are currently witnessing an unusually high level of correlation between the movements of large cap stocks – 81% of shares are moving in the same direction against an historical average of 30%. But with a high starting yield of 5% I think investors are being paid to be patient whilst we wait for value to come from the underlying high-quality assets”.