The big question is where the extra money for the EFSF will come from

In this week’s bulletin:

  • Stock markets globally enjoyed a strong rally last week on the back of the eurozone ‘grand plan’ announced by its leaders. Sentiment was also buoyed by better than expected economic news from China and the US.
  • The latest bail-out measures, whilst light on detail, were sufficient to convince investors that eurozone leaders mean business. The plan has three components: recapitalisation of Europe’s banks; an increased bail-out of Greece and an enhanced eurozone bail-out fund (EFSF).
  • The majority of Europe’s largest banks insist they will not need to tap shareholders or taxpayers for cash but can hoard future profits to build capital, although analysts at Goldman Sachs don’t agree.
  • The big question is where the extra money for the EFSF will come from – China is being rumoured as a potential source of funds as the EU is its largest market.
  • Away from the markets there are key wealth management decisions to be made – how to deal with inflation, how to deal with possible stagflation in the West and how to tap into the huge growth potential of the emerging world? We discuss some of the solutions.
  • Lastly, don’t overlook tax-efficiency – with annuity rates falling, pension drawdown is the solution for some. University costs are soaring and so too is the amount of deposit required to gain a mortgage – the new Junior ISA is a tax-efficient way of accumulating funds for children.

 

Market eye

Global stock markets enjoyed another adrenalin rush last week as a package of reforms announced by eurozone leaders convinced investors that policymakers had finally grasped the nettle. Whilst light on detail, the main thrust of the rescue package was in line with market expectations – anything less would have caused an upset and, in response, many equity indices enjoyed their fifth week of gains as traders and hedge funds switched into ‘risk-on’ mode. Whilst the developed markets enjoyed gains of around 4%, the big movers were Far Eastern markets which advanced 6%, with Hong Kong registering a record week, up 11%, its best performance for many years. Whilst Asia was undeniably relieved that the eurozone debt crisis was being addressed, the real driver for the region was better-than-expected economic data from China. The country’s manufacturing sector rebounded last month, easing fears that the world’s second largest economy is likely to make a hard landing. The sector expanded following three months of contraction, according to purchasing managers’ data (PMI) gathered by HSBC/Markit – the ‘flash’ index combines output, orders and employment and rose to 51.1 from 49.9 in September, with anything over 50 indicating growth. On the back of this news, copper prices surged 14%, leaving oil and gold prices in their wake.

Here in the West, the economic news was mixed to good. Fears of a second eurozone recession mounted after a decline in the region’s services and manufacturing sectors accelerated last month, most probably exacerbated by uncertainty caused by the debt crisis. Markit’s ‘flash’ PMI indicator fell to 47.2 from 49.1 in the previous month, indicating contraction. The British economy may also be contracting, according to Bank of England Monetary Policy Committee member Martin Weale, who said the country is experiencing a weak recovery. His comments coincided with an industrial trends survey released by the CBI, which showed that UK business sentiment had been dented by the eurozone crisis. Whilst the CBI thinks outright recession unlikely, it said it was blatantly evident that manufacturers are being hit by domestic and international headwinds. On the other side of the Atlantic the economic news was better than expected, enabling Wall Street to build on recent gains. According to the US Bureau of Economic Affairs, American gross domestic product (the broadest measure of all the goods and services produced) grew at an annualised rate of 2.5% in the third quarter, up from 1.3% in the previous quarter. A surge in consumer spending and business investment helped accelerate growth, with the latter jumping an astonishing 16.3%, partly because of a rise in sales of computing equipment.

 

Eurozone steps up to the plate

After months of uncertainty, eurozone policymakers finally put together a ‘grand plan’ in a long-overdue attempt to get to grips with the region’s debt crisis, which has threatened to derail the global economy. Just to recap, the plan comprises three key components: bank recapitalisations totalling €106bn, an increase in the Greek bailout to €130bn and finally a beefed-up bailout fund of €1,000bn, including hard cash ‘leveraged’ by insuring bondholders against the first 20% of any potential losses. Whilst there is much detail to come and no guarantee that it will work, financial markets took the view that it was a step in the right direction and an indicator that eurozone leaders had come together to find a solution. No-one expected a panacea and over the coming weeks there will inevitably be doubts about the likely success of the plan, not least of which is where all the extra money will come from.

Taking the banks first, their initial response was to insist that they will not tap shareholders or taxpayers to find the additional €106bn of extra funding identified. This figure is broadly equivalent to 50% of outstanding Greek government bonds in private hands and colloquially known as the ‘haircut’ investors will take on their investment. The European Banking Authority (EBA) has told 90 banks that they must recapitalise their operations by next June to cushion themselves from write-downs on sovereign debt. Banks such as Santander and Deutsche Bank insist they can cover the shortfalls by hoarding future profits, although Goldman Sachs has estimated that banks will only be able to save €34bn via this method. Under the EBA deal, banks that cannot raise the cash must first turn to private shareholders, then to their national governments and as a last resort to the European Financial Stability Facility (EFSF). Notwithstanding the likely complications, share prices in Europe’s banks rallied on the news, with investors breathing a sigh of relief and perhaps taking a more sanguine view than expected.

As to the bailout of Greece, the amount has risen to €130bn from the €109bn agreed only as recently as July and no-one knows whether the country will manage to stick to its austerity programme or, indeed, cope with debts that will still be more than 120% of GDP until 2020. As to the enhanced bailout fund – the EFSF – the single largest question must surely be around the likely source of the new funds needed; analysts estimate that of the original €440bn only some €250bn remains after shoring up Greece. This means that even after the proposed insurance ‘leverage’ – effectively a guarantee given by member states – more new money is needed. There has been speculation that the IMF will need to help out and also that China has been asked to participate via a Special Purpose Vehicle (SPV). There are clear reasons why China should support the deal given that the eurozone is the country’s largest trading partner and that it has no shortage of cash. At $3,200bn, China has the world’s largest foreign exchange reserves, dwarfing those of the eurozone; but it has proven itself to be a savvy investor and the conditions for help could be high. The country is also likely to be wary of part-financing an SPV where the creditworthiness of the eurozone is collectively deteriorating.

Whilst neither analysts nor the markets themselves are expecting a quick fix, investors will be keeping a close eye on developments and maintaining their vigilance. Indeed, at the end of last week focus had turned again to Italy and the country’s ability to reign in its government spending. Investors’ doubts caused the country’s borrowing costs to climb to euro-era highs on Friday, forcing Rome to pay a record 6.06% at an auction of its benchmark 10-year bonds. This brings into sharp focus the key issue underpinning the ongoing crisis – how will all the major developed economies bring their spending under control without seriously damaging global growth prospects? But for now the reform package has been well received and whilst there is likely to be ongoing volatility in the markets in the coming weeks, the mood of investors has undeniably brightened since the low point seen at the beginning of the month.

 

The new world

Irrespective of how events in Europe unfold in the future, one thing is clear: investors still need to make decisions about their future investment plans and to create a viable wealth management strategy. In the last few weeks we have discussed the extensive opportunities that currently exist around income strategies, even if this income is to be reinvested to help grow capital. Equities, corporate bonds and commercial property are asset classes that can all achieve this objective for investors. It is also worth thinking about how a more growth-orientated strategy might be created and weigh up likely future outcomes. With developed economies struggling to grow, it is no surprise that international investors are casting their sights to the emerging world where rates of economic growth are more robust. Economists such as Roger Bootle of Capital Economics believe that, whilst emerging economies may slow, it will be from a higher level (China’s growth is expected to be around 9% this year) and that they will slow gradually because they have lower debt ratios, are less vulnerable to a eurozone crisis and have some room for policy stimulus – particularly as inflation is set to fall in 2012.

Investing in the emerging world comes with higher risk, of course – a survey by the FT showed that 35% of the sector’s largest 500 companies by market capitalisation are subject to state intervention. Specialist global emerging market fund managers, such as Jonathan Asante of First State, recognise this additional risk. “The fund is defensively positioned, invested in businesses with quality franchises and managements with strong track records. Emerging markets fell during the third quarter as markets lost some of their faith that policymakers would contain the problems facing them. Question marks also began to surface about the sustainability of China’s centrally planned economic system – this issue has been around for many years but tends to emerge during periods of rising risk-aversion. The fund has substantially outperformed the benchmark index and recent market falls have broadened our universe of companies of sufficient quality at attractive valuations and we welcome the sell-off of emerging market currencies, as many – the Brazilian real in particular – have been significantly overvalued.”

 

Tactical moves

Elevated levels of volatility in financial markets this year have, unsurprisingly, made investors very wary about committing capital with so much uncertainty. Markets have been pricing in a number of possible scenarios and outcomes in the face of the ongoing debt crisis; but they are not new. A 2010 report from The McKinsey Global Institute entitled Debt and deleveraging: The global credit bubble and its economic consequences shows how debt crises always end in default, austerity packages, high inflation and economic growth. This may sound very familiar: Greece has partially defaulted; austerity programmes are in place across much of developed Europe; quantitative easing has contributed to higher inflation, particularly here in the UK; and, as discussed above, half the world is enjoying robust economic growth. As commented, whilst some uncertainty has been removed, it seems to make sense tactically for investors to maintain a safety-first approach by investing in a balanced portfolio that will help position them for all eventualities but also have the potential to harvest returns as events move on.

There are two key scenarios that investors should think about from a planning perspective – interest rates remaining ultra-low for the foreseeable future and inflation remaining higher for longer. Attitude to risk is obviously central, but within this there are choices. Low cash returns mean negative real (inflation-adjusted) returns: so many investors have moved underweight in this asset class for now and have re-weighted towards higher-income-producing assets as discussed previously. Inflation is unlikely to fall back sharply in the immediate future as commodity prices remain elevated, buoyed by strong growth in emerging markets and possibly pushed higher by further monetary policy stimuli such as quantitative easing. Inflation did fall sharply in the UK back in 2008 but that was mainly attributable to the cut in VAT: it’s unlikely we will see a repeat here given the austerity package in place now. So, if we are to experience an environment of ‘stagflation’ in the developed West but growth elsewhere, how should we position ourselves?

A balanced, geographically diverse, portfolio which combines high-quality assets and produces income makes a lot of sense in the current environment. A judicious mix of some cash, corporate bonds, commercial property, UK and international equities means that the underlying yield is likely to be around 4.3%. As half the income is equity-based it should stand a good chance, based on past experience, of generating a real, inflation-adjusted return as well as capital growth prospects. The other half will still produce income but with less scope for capital growth; and should inflation fall or growth be more muted, then the fixed income element becomes more valuable. So in our view, whilst we are faced with a number of prevailing uncertainties, there are some practical, workable solutions to hand for investors.

 

Don’t forget tax-efficiency

And finally, it’s very easy to overlook the basics of wealth management when the ‘big picture’ is so dominant and potentially clouding the decision-making process. There are some key issues – away from the immediate debt crisis – of which investors need to be mindful. Ultra-low interest rates have, along with increased longevity, driven down annuity rates; which means that for some investors retaining control of their pension assets via the likes of drawdown makes sense. These assets need close management together with an underlying strategy in the way we have discussed. University fees are becoming a huge source of concern for parents and grandparents alike – recent research has put the cost of a degree at anything between £50,000 and £100,000, depending on the type and length of course, the university chosen and whether loans are taken out. Increasingly, parents are looking to create a nest egg for their children to help fund this cost and potentially also to help them onto the housing ladder. From tomorrow, parents will be able to open a Junior ISA (Individual Savings Account) for children born this year (or before September 2002). The funds will enjoy all the same tax benefits as existing ISAs. The maximum annual contribution is £3,600 per child and, as contributions can come from more than one source, grandparents can help out too.

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