In this week’s bulletin:
- Nine out of ninety European banks failed stress tests, meaning they have to raise €2.5 billion between them to cover the potential shortfall
- Italy was the focus of investor concern last week, though no-one can agree on what sparked the worries
- The US President, Barack Obama, attempts to force through a deficit plan before the US runs out of money on the 2nd of August
- The FTSE 100 may not be the diversified portfolio that investors would like, and can carry more risk than expected
- British Sky Broadcasting continues to be in the spotlight, and Nick Purves discusses the recent impact on the share price
Euro banks stress-tested
The week was dominated by mounting concerns over sovereign debt on both sides of the Atlantic, as nerves over stress-tests of European banks and fresh signs of US economic weakness drove equity prices sharply lower, and spurred demand for gold, US Treasuries and the Swiss franc. The results of the tests carried out by the European Banking Authority (EBA), released after the close of European markets on Friday, showed just nine of the ninety banks tested had actually failed the rigorous examination. They will have to raise €2.5 billion between them to cover capital shortfalls. There were a further sixteen that were categorised as ‘nearly failed’. This result was better than most analysts had expected, but The Daily Telegraph reported that the reaction of the City was still that the tests were not harsh enough. The criteria were accused of being overly optimistic, and failing to capture the potential severity of the situation across the eurozone. Andrea Enria, chairman of the EBA, insisted that the organisation had been thorough, though he admitted that the economic situation had worsened since the criteria had been originally set. This prompted analysts at BNP Paribas to comment, “The public perception is that the exercise was not tough enough to see many banks fail, but just tough enough for a few to fail, and this will prove hard to correct.” Of the nine banks to fail, five were Spanish and two were Greek. The others were one Austrian and, somewhat surprisingly, one German bank, Helba.
George Osborne, the Chancellor of the Exchequer, seemingly agrees with the City analysis as The Mail on Sunday reported that he was set to clash with Brussels overBritain’s right to make its own rules for British banks. Mr Osborne sees the results as evidence that the country must be free to govern rather than to abide by lower European standards, and wants to make British banks as trusted as possible, keen that his country’s banks are not tarred with the same brush as their European counterparts.
Attention turns to Italy
The early part of the week saw Italy as the focus of investor worries, as the yield on its ten-year bonds briefly rose above 6%, a level viewed as critical in terms of the country’s financial stability. Although this level quickly eased back after €5 billion debt auctions on Tuesday attracted reasonable demand, the bonds remained under pressure throughout the week, despite politicians backing €45 billion austerity measures. The panic over Italy’s €1.8 trillion sovereign debt mountain had eased by the weekend, after the auction, albeit with the country paying its highest rates in the euro era. The Financial Times opined that the real issue that rocked investors was the suddenness of the news rather than the news itself. No-one can agree what sparked the rise in Italian bond yields or, more importantly, whether investors have completely lost confidence in the country’s ability to service its debt. One of the most common theories behind the bond market rout has been the positioning of investors after Greece, Ireland and Portugal fell out of the main bond indices. Needing higher-yielding bonds, investors went to Italy which was seen as safer than Spain, so after bond yields started to rise, already-worried investors retreated en masse, sparking the exaggerated panic seen early in the week.
As The Sunday Times reported, time and time again during the European sovereign debt crisis EU finance ministers have relied on short-term fixes rather than secure a lasting solution to the deficits racked up by Greece, Ireland, Portugal and Italy. Bond markets now seem to have lost patience with the failure of policymakers, and it is this which triggered the latest bout of volatility. The euro sank to a four-month low against most major currencies, amid speculation over the EU’s third largest economy and the opinion amongst analysts is that this uncertainty is something the eurozone can ill afford. Western equity markets fell in excess of 2% despite the rally in the second half of the week, with the FTSE 100 closing at 5,843 and European markets experiencing their worst week since February. Gold was driven to a record high in excess of $1600 per ounce as the threat of a fresh bout of quantitative easing in the US continued.
President Barack Obama pleaded to his country for a “shared sacrifice” in a last desperate attempt to achieve agreement on the US’s $14.3 trillion debt ceiling, the amount that it can legally borrow. The Sunday Telegraph reported that there could be a highly volatile reaction should politicians on Capitol Hill fail to make significant progress, and Mr Obama believes that all sides need to make compromises. Reports have emerged that August 2nd is the date at which the US will no longer have the money to service its debt; but US Treasury investors seem somewhat relaxed about the situation, believing there to be little chance of Congressmen risking the country’s first default in its history. The crisis talks are beginning to echo the difficulty that Congress had in 2008 when passing a $800 billion rescue package, which was ultimately forced through after volatility in bond and equity markets.
The impasse in Washington is already starting to cause concern among foreign owners of the debt. China, the largest holder with around $1.1 trillion, voiced its anxiety publicly and ‘hinted’ that the US should protect the interests of its overseas creditors. Mary Miller, a senior official at the US Treasury, spent the week reassuring foreign investors that a deal would be struck, which is crucial because more than half of US Treasuries are collectively owned by non-US investors. Part of these discussions is speculated to have involved arguments over how the US should cut the deficit, on which Mr Obama presented his own views. He used his weekly address to argue that ending tax breaks for oil companies and wealthy individuals needed to be part of the agreement. Without a deal to boost borrowing limits, the President also warned that interest rates could rise and in effect increase taxes on all Americans. The Financial Times commented that ratings agencies are keeping a keen eye on developments, with Standard & Poor’s already claiming that the US has a 50% chance of losing its AAA status even before the resolution of this current situation.
The composition of the FTSE 100 was the focus of The Times, which highlighted the shift towards mining, commodities and banking. More than half of the FTSE 100 by capitalisation is exposed to these sectors, while companies in the index derive around 75% of their profits from overseas, resulting in a lack of diversification and a certain amount of currency risk to any tracker portfolio. The paper opined that while many investors think they are getting a fairly simple low-cost portfolio, the headline index is not properly diversified to take best advantage of a full market cycle. Instead the index is over-exposed to commodity fluctuations, and often lacking in defensive companies, offering little exposure to the domesticUK economy. FTSE 100 companies have been traditionally seen as secure blue-chips with a stable dividend yield, but in reality, with the growth of mining and commodity stocks, this is no longer the case.
Opportunity in the sky
The media scrum surrounding News Corporation, whose share price is now 20% lower than it was two weeks ago, resulted in top shareholders forcing the resignation of chief executive Rebekah Brooks. Pressure continues to mount on senior executives, with major shareholders in the Middle Eastbeing particularly vocal over the need for a fresh start at board level.
Investors in British Sky Broadcasting hoping for a £1 billion special dividend after the collapse of News Corporation’s attempted takeover are likely to be disappointed, according to The Mail on Sunday. There had been suggestions that BSkyB would make a special payment on top of the usual dividend if the bid failed, but this is now unlikely to happen. The company’s shares plummeted last week after the approach was withdrawn, but one investor happy to hold the stock is Nick Purves of RWC Partners.
“We purchased shares in BSkyB at an average price of 543p. At the time of writing the shares are priced at 680p. Since the time of purchase the company has paid around 70p of dividends to the fund and the total return to date on the shares is therefore just under 40%. This compares to a total return on the FTSE All-Share Index of less than 10% during this period. In this context, the shares have been a reasonably successful investment.
“We bought the shares in the belief that the company was very well managed but not realising its full profit potential, as the company had been reinvesting a significant portion of its profits back into the business in order to drive future growth. An example of this would be the early move into high definition which has proven to be a success and has enabled the company to increase its market share in the UK.
“In the company’s current financial year, to June 2012, Sky is expected to report earnings of between 45p and 50p and it would therefore appear that our view of the company has been vindicated. It is this improvement in profitability that drove News Corporation to make an offer for the 60% of the equity that it did not already own. Whilst it is clearly disappointing that the bid is now very unlikely to go through as this has lead to a drop in the shares from 850p, the numbers above suggest that there is value in the shares on a standalone basis. Accordingly, we believe that it is right to continue to hold the shares.”