likely loss of up to 50% on the Greek sovereign bonds

In this week’s bulletin:

  • As the eurozone sovereign debt crisis rumbled on last week investors suffered bouts of uncertainty mixed with optimism, creating continued volatility in global markets. Notwithstanding, developed economy equity markets posted some small gains unlike in the Far East where China’s latest GDP data disappointed.
  • Having originally committed themselves to a deadline of yesterday for announcing a solution, the eurozone’s leaders gave themselves more time and deferred decision day until this coming Wednesday. However, progress has been made and it was announced that some €100 billion will be needed to recapitalise some of Europe’s banks.
  • The reason for this is the likely loss of up to 50% on the Greek sovereign bonds they own and a necessary component in the rescue plan being devised. The stumbling block is apparently the size of the EU bail-out fund which needs to be increased significantly – France is not keen to agree a form of leveraging as this might jeopardise its AAA credit rating.
  • Here in the UK, the BoE announced a shock rise in the Consumer Price Index to 5.2% – mainly driven by higher energy costs hitting households. The net outcome is that savers are being squeezed with a combination of taxation and inflation that mean savings accounts are giving returns that are negative in real terms.
  • One solution is for investors to diversify into assets with a track record of beating inflation and equities are one asset class that have achieved this over the medium to long term.


Market Eye

Uncertainty, interspersed with rushes of optimism, characterised global financial markets last week as the eurozone approached its 11th hour. With EU leaders having met this weekend to finally come up with a realistic solution to the eurozone crisis, the markets ratcheted up the pressure. Amidst all the angst, global economic news was mixed to positive: US corporate earnings have, for the most part, been positive with few disappointments outside the banking sector; illustrating resilience on the part of businesses to maintain their margins. Released US data showed that the world’s largest economy has, fortunately, managed to sidestep recession; although signs of momentum picking up remain scarce for now. Activity in the construction industry grew last month with firms starting work on more new homes during September – housing construction jumped 15% with demand for apartments leading the way. Inflation figures came in lower than expected: the US Consumer Price Index rose just 0.1%. Muted inflationary pressures will leave the door open for the US Federal Reserve to embark on a further round of quantitative easing (QE) should signs emerge that the economy is stalling once more.

Inflation here in the UK is unfortunately much higher than forecast and proving to be very stubborn, despite the Bank of England’s (BoE) assertions that it will fall back sharply in the coming months. (We discuss the implications of this later on.) In terms of growth, the BoE has sharply downgraded its forecast for the rest of the year, cutting the rate to “close to zero” according to the minutes of the BoE’s Monetary Policy Committee’s (MPC) August meeting. This helps explain why committee members voted unanimously to instigate a £75bn programme of gilt purchases (QE2) over the next four months, in efforts to boost growth. In an extract from the minutes the Bank said, “In the UK, the path of output has been affected by a number of temporary factors but the available indicators suggested that the underlying rate of growth had moderated and would be close to zero in the fourth quarter.” A swift resolution to the eurozone crisis has become imperative: not just for the region’s members, but also for the UK.

In the equity markets, volatility remained elevated, with prices enduring a seesaw ride throughout the week as rumours and counter rumours swirled around about how much progress was being made by EU policymakers in time for the weekend’s summit. As it transpired, a second summit was announced to be held this coming Wednesday, following deadlock between France and Germany over the terms of the expected deal. A German spokesman said that although the original meeting would proceed, there would be no agreements announced until this Wednesday at the earliest. In the meantime, markets meandered but most major Western indices managed to gain some ground over the week, although Far Eastern markets fell back over concerns about China possibly heading for a hard landing as investors deemed third-quarter GDP figures disappointing.


Markets Expecting a ‘Bazooka’

The eurozone imbroglio has severely tested the nerves of both investors and policymakers but time is now about to finally run out. Whilst the markets will have to wait until this Wednesday for the details, it is clear that EU leaders will address the three key issues: investors being forced to take a ‘haircut’ of anything up to 50% on Greek government bonds; recapitalisation of many of Europe’s banks following this event (mainly French and German); and a bailout fund of adequate size (the European Financial Stability Facility (EFSF)) to convince the markets that sufficient firepower is available to buy up every Spanish and Italian government bond should the need arise. In other words, the markets are expecting a ‘bazooka’ solution. Should it fall short then, potentially, disappointment could ensue according to analysts.

Overnight, Chancellor George Osborne has declared “real progress” after a meeting of EU finance ministers in Brussels on the eurozone debt crisis. A provisional deal will see banks raise more than €100bn ($140bn; £87bn) in new capital to shield them against possible losses to indebted countries. It is conditional on a wider accord, including a write-down of Greek debt. Mr Osborne said: “Britain will keep up pressure in the next few days to a comprehensive package to resolve the European crisis and to make sure that we get jobs and growth.” Earlier in the week the EU estimated that its banks needed €100bn to shore up their capital base but this figure falls far short of the €200bn recently identified by the IMF and analysts’ own estimates of €275bn. Some of the discrepancy is, apparently, down to the EU including the value of the banks’ entire portfolios of European sovereign debt – this means that the increased values of German, UK and French bonds are being offset against potentially delinquent Greek, Portuguese and Irish bonds. With equity markets trading positively this morning, it seems that for now investors are prepared to go along with the assessment that €100bn will form a sufficient buttress for the banks.

In the meantime, Greece has secured the next €8bn tranche of international funding following its parliament passing another tough austerity package, despite a leaked report showing that EU officials have concluded that the €159bn Greek bailout agreed three months ago is no longer adequate. The country’s financial situation has deteriorated significantly it seems since the vast bailout was agreed. Indeed, there has been speculation that global lenders would have to find €252bn in bailout funds through to the end of the decade unless Greek bondholders are prepared to take an even larger 60% ‘haircut’. This leaves the final component to be addressed: the size of the EFSF, which at €440bn is acknowledged as being woefully inadequate by politicians and the markets alike. This is proving to be a sticking point between France and Germany: leverage of the EFSF to nearer €2 trillion would likely mean France losing its coveted AAA credit rating, which would push up its future borrowing costs in the markets.

To overcome this potential impasse, there is speculation that the IMF will need to be involved in either direct funding or underwriting the guarantees given by the EFSF. The argument is that the eurozone crisis is now a global problem – not one solely confined to the EU – and, as such, the IMF’s largest shareholders – the US and China – have a deeply vested interest in helping solve the crisis. It is also possible that eurozone leaders will be able to tap the world’s largest sovereign wealth funds – such as of Norway, Singapore, China and the Middle East – as an additional source of funding for their grand plan. For now, the details of the plan are being kept secret; but with the rules of engagement having been set by the markets in terms of expectations, then nothing less than a comprehensive solution will be acceptable. The very final requirement – mentioned by the Chancellor – is the urgent need for policymakers to also deliver economic growth and jobs. To date, political paralysis is threatening Europe – and possibly the UK – with a potential recession or at best, according to economists such as Roger Bootle, very low growth.


Inflation Problem Growing

Away from the eurozone, the UK has its own problems to deal with. Last week’s shock inflation figures may have taken the BoE aback but it’s likely they caused little surprise to householders who have had to cope with rising fuel and food bills and also seeing the value of their savings and pensions shrink. Last week the BoE announced that the Consumer Price Index (CPI) jumped to 5.2% in September – significantly above its official 2% target. For the over-75s, Saga has estimated that real inflation is closer to 6.5%. Falling in-between is the Retail Prices Index (RPI) which includes housing costs within its basket. The ramifications for every household are very clear and none more so than for savers and those retired who rely on the interest generated by their savings to maintain their lifestyles. “The Retail Prices Index rose to 5.6% in September, the highest rate since June 1991. With interest rates at a record low, it means that savers are getting the worst real-term returns on deposit accounts and cash ISAs since BoE figures began in the mid-1990s,” according to James Knightley, UK economist at ING Bank, who added that it could be 2014 before savers received returns that were better than inflation.

So with base rates at their historical low after they crashed some two and a half years ago, savers are struggling to achieve a real, inflation-adjusted return on their deposits. The chart below illustrates very clearly the growing shortfall between cash returns and inflation.


Inflation versus interest rates over 20 years






Source: Bank of England / Office for National Statistics – September 2011

Indeed, by the time you take account of both tax and inflation, you are guaranteed to earn a negative real return. A basic-rate taxpayer needs to earn 6.5% gross from their savings account to achieve a real return: a higher-rate taxpayer needs to earn at least 8.7%; and an additional-rate taxpayer, 10.4%. A review of the Daily Telegraph’s ‘Best Buys’ for savers showed that current rates range from as little as 2.7% for instant access to only 4.6% for a five-year bond, which means a negative real return. Clearly, everyone needs a liquid cash reserve and using tax-efficient wrappers can, at least, shelter these lowly returns from taxation.

One solution to this problem is to consider other forms of income-generating assets and these might include investing in a portfolio of corporate bonds, a commercial property portfolio or an equity income portfolio. Last week we examined the merits of equity income investing and highlighted the fact that it is possible to achieve high levels of income which stand a good chance of growing over the medium to long term faster than the rate of inflation. As a reminder, long-run inflation is 3% whilst long-run equity dividend growth is 4–5%, meaning a real increase in income. Again, the chart below illustrates that, notwithstanding capital fluctuations, equities are more likely to deliver a real, inflation-adjusted return to investors.


UK equities versus cash (net returns)






Source: Barclays Equity Gilt Study 2011. Real return on UK equities, cash and gilts (gross income reinvested) after the impact of inflation. Data for each calendar year running from 1st January to 31st December, as at 31/12/10. Past performance is not indicative of future performance, and the value of your investment(s), as well as any income, may go down as well as up. Equity-based investments do not provide the same security and capital characteristics of bank or building society deposits.

Of course, the risks are different and investors need to ensure they have a diversified portfolio commensurate to their individual risk profile when considering their options. But as an indication, a balanced portfolio containing a mix of corporate bonds, property and equities can generate an initial income of around 4.6% net of basic-rate income tax. The greater the equity element, the greater the chance that income will rise in real terms, based on past data and experience. One final point is to consider how long inflation might remain at its current high level. The BoE argues that it expects a re-run of 2008 when inflation dropped from 5% to below 2%; but that presupposes energy and commodity costs stabilise and are not driven higher by increased demand from the emerging world. Whilst we may be experiencing slower growth in the West, economist Roger Bootle estimates that the developing economies are likely to grow at an aggregate rate of around 4% over each of the next three years, implying continued high levels of demand for the world’s limited resources. Our own view is that investors seeking to protect their wealth in real terms therefore need to be vigilant and position themselves accordingly by ensuring they have a diversified portfolio with assets demonstrating a history of inflation-proofing.

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