In this week’s bulletin:
- Ongoing problems in the eurozone and rising inflationary pressures caused investors to head for the relative safety of government bonds and gold last week.
- Sharply rising commodity prices are causing problems globally, particularly in China where the government introduced price controls and implied the yuan would be allowed to appreciate.
- Inflation fell unexpectedly in the UK last month reflecting the inability of businesses to pass on price increase to cash-strapped consumers – retail sales fell 1.9% in March, the worst for 16 years.
- The increasing likelihood of Greece having to undergo a complete debt-restructuring was enough to frighten bond investors who fear they may have to take a severe ‘haircut’ should it happen – 2-year yields shot up to almost 18%.
- Global equity markets remained calm as investors took a sanguine view of events.
- Fund manager, John Wood of JO Hambro explains why he thinks UK equities are the forgotten asset class.
Going for Gold
Worries over sovereign debt default, uncertainty about central bank policy and somewhat disappointing corporate earnings chipped away at investor confidence last week, causing investors to, once again, head for the safety of government bonds and gold. Gold, driven by ongoing attention to inflationary pressure – particularly in China – closed at an all-time high of $1,488 per ounce, with silver also hitting a 30-year high of $42 an ounce. Elsewhere in the commodity markets though, the price of oil and copper fell back – partially on the back of a research note from Goldman Sachs’ commodity team who effectively called time on one of its major trading strategies. The broker advised its clients to close their play on oil, copper, cotton, platinum and soybeans as their analysts argued that, after gaining 25% since December, risks to the trade had changed. The broker left its options open though, saying that there was still potential upside for these commodities, taking a twelve-month view.
Also keeping the commodity story on the front page was news that Swiss commodities giant Glencore’s initial public share offering would value the company at about $60bn, meaning the company went directly into the FTSE100 as one of the UK’s largest businesses. Glencore surprised even seasoned traders when it divulged the true extent of its control over world commodities – 60% of the zinc market, 50% of copper, 48% of lead, 38% of alumina and almost a third of thermal coal. The timing of Glencore’s IPO may, with the benefit of hindsight, be perfect if Goldman Sachs are proved right in their calling a temporary halt to rises in the commodity markets. There are many policymakers who may well be hoping they’re right because the implications of sky-high commodity prices have been making themselves very evident – from food riots in emerging countries to higher inflation across parts of the West, but also in China as mentioned.
Data released on Friday showed a surge in Chinese and Indian inflation, highlighting the threat to the global economic recovery from rising commodity prices.
Consumer prices in China rose 5.4% year-on-year in March – the largest jump since July 2008. In India, headline inflation rose to almost 9% last month – up from 8.3% the previous month. To combat inflation, emerging markets are tightening fiscal policy, potentially reducing an important source of global demand for struggling developed economies. To put this in perspective, according to Deutsche Bank, the four BRIC economies – Brazil, Russia, Indian and China – account, by currency, for around 23.5% of global GDP, with China responsible for almost half that figure. This compares to a similar percentage for the US and UK combined. As the prices of raw materials such as oil rise, buying power is being redistributed from commodity consumers in Europe, the US and China to producers such as Saudi Arabia who are unable or unwilling to spend their windfall quickly, causing a fall in global demand.
Last week the International Monetary Fund (IMF) also made its own views known, saying that China, along with other emerging economies that it believes are overheating, face the threat of a property sector boom and bust that could lead to a sharp downturn in growth. After growing by more than 10% last year, China is still expected to grow by 9.5% both this year and next, despite the People’s Bank of China raising interest rates and liquidity requirements for the banks several times in recent months. “The challenge for many emerging and some developing economies [Germany] is to ensure that present boom-like conditions do not develop into overheating over the coming year,” said the IMF in its World Outlook report. China’s policymakers are well aware of the problem higher prices are causing its people – the average household spends around a third of its disposable income on basic food, which has been rising at over 10% in recent months. So following the latest data it was no surprise that the country imposed strict price controls on basic consumer goods and decided to take action on its currency. China’s premier, Wen Jiabao, said that Beijing would also “further improve the yuan exchange rate mechanism and increase yuan exchange rate flexibility to eliminate inflationary conditions”. Analysts said that, apart from being the first time Mr Wen had publicly aired the issue, it meant Beijing would allow their currency to appreciate, to try and increase its spending power to choke off higher prices.
Surprise for UK
In complete contrast to China, Britain’s economy offered policymakers cause for cheer as inflation fell back for the first time in eight months and a shrinking trade gap stoked hopes that an export-led recovery is, at last, underway. The greatest surprise was news that official inflation, the Consumer Price Index, came in much lower than expected at 4.0% for March, down on the consensus forecast that it would stay at 4.4%. The fall was unexpected by economists, who had focused on continued rises in raw materials but not withstanding, CPI is still twice the Bank of England’s 2% target. According to the British Chambers of Commerce, “The fall in inflation points to sharp competitive pressures in the high street and confirms our assessment that businesses are unable to increase prices while disposable incomes are being squeezed”. The BCC probably have a point as, earlier in the week, data released showed that the high street recorded its largest fall in sales in 16 years during March, as disposable incomes were hit by higher inflation and wage restraint. There was one bright spot though – Britain’s unemployment rate fell unexpectedly in the three months to February. According to the Office for National Statistics, unemployment dropped by 17,000 to 2.48m, pushing the rate down to 7.8%.
The recently agreed, in principle, bailout of Portugal should have meant that some heat was taken out of the ongoing sovereign debt crisis. It seems to have been a brief respite. Last week, as officials from the EU, ECB and IMF met to construct the terms of the rescue package with the Portuguese authorities, domestic political squabbling threatened to jeopardise the deal and destabilise the single currency. The proposed changes are likely to be even more swingeing than those proposed by the Portuguese Prime Minister and with a national election not far away, no politician wants to be associated with unpopular cuts. Economic analyst Vanessa Rossi said “I am not sure what they are going to do in the next few weeks if they cannot get a deal”. But, deal or no deal, it may still not guarantee success, as Greece found out last week.
Greece was the first country to be bailed-out by the EU and IMF in return for harsh austerity measures being taken which, unsurprisingly, have proven very unpopular. The bond markets have however, continued to keep a close eye on events and it appeared last week that some investors remain unconvinced about the final outcome. Following comments from the Greek and German finance ministers, speculation heightened that Greece would have to undergo a complete debt-restructuring exercise which could mean investors holding the country’s bonds could lose some of their money. The head of rating agency Standard & Poor’s European debt-evaluation group warned that investors might suffer a “haircut” – read loss – of 50%-70% on their holdings of Greek debt if such a restructuring took place. Markets reacted quickly; the euro fell and both Greece’s and Portugal’s borrowing costs rose sharply as traders priced-in the possibility. Borrowing costs on Greek two-year bonds spiked to 17.9% (compared to 1.86% for a German Bund) after Germany’s finance minister said that “further measures” may have to be taken if a study proved that Greece’s finances were unsustainable.
Against this continued uncertainty, global equity markets remained remarkably unmoved as investors took a phlegmatic view of events. The rationale seems logical – The Financial Times commented that, in the eurozone, the markets have doubted Greece’s solvency for some time and rising yields have reflected the view that a restructuring of the country’s debt was inevitable. On China, a slowdown in growth would be welcome as it would lessen inflationary pressures and a rising currency would benefit exporters like America, who have complained that the yuan has been kept artificially low. So by the end of the week most major equity markets had moved little overall – Wall Street softened by less than half a percent whilst the Shanghai Composite rose by a similar amount.
Quality at a Discount
The ascendancy of emerging markets is nothing new but there are some investors who feel that the price being asked to participate has become too high. Leading UK equity manager John Wood, of JO Hambro Capital Management, believes that the current commodity-based euphoria has all the hallmarks of the late nineties ‘TMT’ boom. “Currently there are two elements to markets: the real world and what I see as a casino where speculators are prepared to buy assets at unbelievable prices. People seem to have forgotten the risks associated with emerging markets. For example, South Africa’s interest rates are 9%, which means there are greater risks than elsewhere – it means the government could walk off with investors’ assets. This has led to the likes of UK equities have becoming the forgotten asset class because, despite rising earnings, increasing net asset values, share prices remain depressed. In other words, intrinsic value has grown faster than share prices and it means the portfolio is better value now than in March 2009, when the market hit its nadir in price terms.
Whilst we all know the UK economy is struggling – the recent retail numbers show there has been no like-for-like growth in food sales, which means household finances are under huge pressure – there are good British companies out there. These are businesses with strong brands that are very profitable. Next is a good example – it offers a good margin of safety which I always look for. The company operates on 15% margins, yields 4.0%, is retiring capital [via share buybacks] yet only trades on a p/e of 8. On the basis of fair value, the share price should be £36 not the current £24. I continue to look for areas offering structural growth where investment themes will be rewarded, such as outsourcing and ageing population, involving companies like Compass Group and GlaxoSmithKline. So in summary, I have continued to buy volume growth where there is not any GDP growth, buy value creation where there is no volume growth and not to lose sight of the fact that high returns compound over time”