US Federal Reserve unveiled its much vaunted ‘Operation Twist’

In this week’s bulletin:

  • Stock markets were once more extremely volatile last week with two key issues at the centre of investors’ concerns: the eurozone crisis and the outlook for global growth
  • The eurozone outlook deteriorated further as Standard & Poor’s unexpectedly downgraded Italy’s credit rating to ‘A’ causing yields on Italian government bonds to rise close to the 6% level – considered a tipping point by the markets – S&P’s concerns revolved around the government’s resolve to implement austerity measures
  • Growth worries intensified as purchasing managers’ data showed the eurozone slipping below 50 on the PMI index – a level consistent with economic contraction
  • The US Federal Reserve unveiled its much vaunted ‘Operation Twist’ which involves the sale of short-dated bonds for longer-dated ones, so helping to keep borrowing rates low – this was largely ignored by the markets which were, instead, upset by comments from Ben Bernanke about downside threats to the American economy giving rise to fears of a ‘double-dip’ recession
  • In response, global equities and commodities went into reverse – including gold – as investors headed for the perceived safety of US, UK and German government bonds.
  • With the economic outlook for the developed world undeniably cloudy the one bright spot is the emerging world where too much growth has been a problem for some. Whilst they are not immune from a slowdown in the West, countries like China are endeavouring to rebalance their economies on the back of increased domestic consumption as opposed to just relying on exports. The emerging world looks set to enjoy a decade of strong growth with all the associated investment opportunities.
  • One asset class overlooked during the recent crisis is commercial property – fund manager Chris Bartrum discusses the merits of including this asset class in a diversified portfolio.

Market Eye

Investors were subjected to another severe bout of volatility in global financial markets last week as worries resurfaced once more over the eurozone crisis and the outlook for economic growth. In Europe, frustration continued to grow over the lack of co-ordinated and firm action by policymakers to deal with the debt crisis and specifically Greece. Reassuring noises emanated from Athens mid-week along the lines that further cuts would be forthcoming which would be sufficient to satisfy the ECB et al and thus secure the next €8bn tranche of emergency funding. The cost was high – another 20,000 public service job cuts in addition to the 80,000 already agreed – so it was little wonder that there were further demonstrations in Athens over the swingeing impact of the latest austerity cuts. Investors briefly enjoyed a respite as markets rallied but were again stopped in their tracks on news that, unexpectedly, Standard & Poor’s downgraded Italy’s credit rating to ‘A’, five notches below the top-ranking AAA grade. The rating agency cited concerns over the Italian government’s resolve to implement the necessary budget cuts already promised – the yield on Italian (and Spanish) bonds rose ever closer to the pivotal 6% level which are seen by the market as unsustainable in the long term.

With investors’ nerves already taut, they were further unsettled by news – albeit anticipated – that the US Federal Reserve was to embark on a new form of quantitative easing (QE) in the form of ‘Operation Twist’. The policy involves the Fed selling $400bn of short-dated government bonds it owns to buy debt with longer maturities in an attempt to drive down further long-dated bond yields. The ten-year benchmark US Treasury bond already yields less than 2% but the intention is to make borrowing cheaper for longer, hopefully encouraging consumers and businesses to spend and thus stimulate growth. But it was Fed chairman Ben Bernanke who spooked the markets when he talked of significant downside risks to the US economy – this was interpreted by investors as impending recession for the world’s largest economy with all the ramifications for global growth. In response, global stock markets fell sharply with most major indices falling 5% on Thursday as investors headed for the safer havens of US, UK and German government bonds. Even gold appeared to have lost its lustre, falling over a $100 per troy ounce on the week. The potentially good news was that the price of oil and other commodities fell which ultimately will reduce inflationary pressures.



So what has changed for the markets to be worried, once more, that the West is about to slip back into recession? Just a few months ago there was growing optimism that developed economies would enjoy near trend growth and that the global economy would enjoy growth in GDP of around 4%-5% this year. The Japanese earthquake clearly impacted on global supply chains but is not in itself the single reason. It is now clear, according to some economists, that the effects of earlier policy stimulus introduced in response to the Lehman crisis are now wearing off and in some cases the stimulus is being reversed by those countries that have embarked on austerity cuts. Consumer balance sheets – unlike the corporate sector – are very stretched in the Anglo-Saxon countries and spending is falling as households pay down debt. Rising inflation is exacerbating the problem for consumers – an outcome of earlier stimulus policies which created the ‘wrong’ kind of inflation i.e. sharply higher commodity prices. The banks remain weak, despite some recapitalisation, especially in Europe and are reluctant to lend. Finally, the eurozone sovereign debt imbroglio has deteriorated into a crisis as a result of political paralysis and has severely damaged confidence.

Last week there was some evidence that the combination of these factors is threatening growth. The September Market Purchasing Managers’ index gave the strongest sign yet that the eurozone’s economy is sliding back into recession. The headline index fell from 50.7 to 49.2 – any number below 50 implies economic contraction. The survey suggested that Europe’s services sector is performing particularly badly and that the slowdown has extended to the largest economies of France and Germany. The International Monetary Fund (IMF) also warned about the threat to the global recovery last week as it downgraded its forecast for world growth from around 5% to nearer 4%, with the largest contribution coming from the developing world. The IMF said escalating risks to world recovery mean the US and other major economies should not sharply tighten short-term fiscal policy. This means economies like the UK have to negotiate a fine line between retaining market confidence by continuing to stick its deficit cutting plan and also stimulating growth. Economists along with industry leaders are urging action by the Chancellor to help the economy. Some ideas are new like reducing the banks’ capital cushion for loans to small businesses. Another is for the Bank of England (BoE) to inject finance directly into small company balance sheets by investing in securitised bundles of loans to such businesses. In response, Mr Osborne has promised concerted help which will be announced in his autumn statement.

The Fed’s decision to intervene via ‘Operation Twist’ is likely to be followed by further intervention by our own BoE following the release of this month’s MPC minutes. The language has changed, with the BoE believing that the growth outlook has weakened to such an extent that inflationary risks are on the downside and that further stimulus (QE) would be needed. So would QE2 work here? In its quarterly report the Bank estimated that the first round of QE, which involved the purchase of £200bn of assets, mainly gilts,  between March 2009 and January 2010 saw a peak effect on the level of real GDP of between 1.5%-2%. Hence expectations have risen that the BoE will launch a new round of QE in November. The greatest perceived risk to such a move would be the impact on sterling which would most likely fall – this would potentially lead to higher consumer price inflation as the price of imports would rise. Conversely, a fall in sterling would make our exports cheaper and so give manufacturers a potential boost which would likewise boost growth. Again there is a fine line to be trodden – if international investors take the view that the Bank is deliberately trying to inflate its way out of trouble via currency devaluation then sterling could get hurt. For now, the market is pricing in how much QE will be, rather then if it is going to happen.


Europe – Time is Running Out

The eurozone has six weeks to resolve, once and for all, its sovereign debt crisis before the global economy hits the danger zone, according to Chancellor George Osborne. He, along with other members of the G20 group, warned European leaders not to prevaricate further and that patience is running out in the international community. As discussed, Italy’s credit rating downgrade coupled with poor economic data has increased the pressure for a workable and lasting solution to the debt crisis to be found. And the numbers appear to just get larger – according to the IMF, Europe’s debt crisis has exposed the region’s banks to €300bn of potential losses. The organisation said certain European banks need to urgently bolster their capital buffers to protect themselves.

The sharp fall in share prices last week has achieved one thing – it appears to have galvanised policymakers in Europe into action. Over the weekend news began to emerge that a major initiative was being put together by eurozone leaders. They have pledged to pass legislation by mid-October to make their rescue fund, the European Financial Stability Facility (EFSF), more flexible and to maximise its impact to address the contagion within the region. Discussions appear to have revolved around several key components which in aggregate could work. The first step would be wide scale recapitalisation of European banks in France, Germany and beyond to allow them to absorb sovereign debt losses, regain access to funding markets and reverse the destructive contraction of credit currently sweeping the eurozone. This would be followed up by measures to leverage the EFSF using liquidity provided by the ECB to the tune of several trillion euros (the numbers range from anything between €2-€6 trillion) – enough to protect larger nations such as Italy and Spain. These two countries between them have almost €2.5 trillion of sovereign debt outstanding. Once in place, an orderly default by as much as 50% of the value of Greece’s sovereign debt would be sanctioned. The question for the markets now is whether policymakers have the resolve to deliver such a solution and, crucially, fast enough.


Emerging World Ahead

Whilst the outlook for growth in the developed economies is cloudy, few observers, including well-known fund managers such as Neil Woodford, seriously expect the US or UK to go back into recession. Rather, the very low growth that is likely will perhaps feel like a recession but will also mean interest rates are likely to remain at near-zero for a number of years. Some observers have drawn parallels with Japan’s lost decade, implying a similar outcome for some developed economies. The circumstances are, fortunately, different for the West today.  In Japan, asset prices were grossly overvalued in the lead-up to their bubble bursting and their banking system was left to its own devices instead of being cleansed and recapitalised. Undeniably though the US, the eurozone and the UK will inevitably face a long slog back to prosperity. Fortunately, the other half of the world – the emerging or developing economies – does not have the same problem and therein lies the investment opportunity. Economists such as Roger Bootle, of Capital Economics, rightly point out that growth prospects in these dynamic economies are significant. Of course, many rely on commercial trade and exports but countries like China and India are looking to grow their own domestic economies which will be a source of new economic growth in itself. The chart below illustrates these points.

Unlike the West, many developing economies have conducted their short-term macroeconomic management with competence. These countries have carved out for themselves an unprecedented degree of counter-cyclical freedom by building up foreign exchange reserve buffers and fiscal surpluses. It makes sense therefore for any long-term investment strategy to be positioned to capture the strong growth from Asia and the like. Recent stock market falls have been indiscriminate on a global basis, leaving the share prices of many high quality businesses trading on very low price multiples, giving investors the chance to capture good levels of dividend income and growth prospects at lower cost.



The Case for Property

The case for equities has been discussed more than once in recent weeks but it is important, from a risk management perspective, to maintain a diversified approach to asset allocation. One asset class little talked about during the recent volatility in financial markets is commercial property; capital values have been stable along with its main attraction, relatively high levels of rental income – particularly when compared to the benchmark 10-year gilt, as illustrated below.

Commercial property fund manager Chris Bartram, of Orchard Street, recently explained the attraction of commercial property for investors. “Stable income return, with potential for capital growth. Stable income because income is derived from leases, which are terms-of-years contracts. They’re subject to credit risk – not to be overlooked – but subject to credit risk, it is a stable income return, the price of which will go up and down. It is a high-income return. The portfolio yields around 6.5% gross, so not only does it endure for the duration of the contract; it is high, relative to other asset classes – particularly with reference to long-term government securities. Historically, it’s also been a good hedge against inflation.  I remember when inflation was brought under control in the 1980s; there was a great debate about whether property should have a place in portfolios. It’s been rather a star performer in portfolios in times of low inflation.  But when we had higher inflation, what one finds is that, for a variety of reasons, the level of rents adjusts over time to inflation. So, not only do you have a stable and a relatively high rate of income, there are good reasons to suppose, over time, that the rent will adjust to inflation and so it becomes an inflation hedge as well.

Property remains below its peak value. In the last ten years it’s moved dramatically up and then dramatically down followed by a recovery; but by no means all the way.  The recovery to date though has been uneven. Prime retail assets and Central London offices have led the charge, leaving behind quite a lot of other areas of property – provincial markets in particular, in offices and in industrial warehouse properties – and maybe that produces opportunity for the future. But, as I’ve said, with its high yield, it’s not reliant on meeting any targets for capital appreciation.  We know we are in a low-growth economy and I’m not saying anything’s different for property investment markets but, where we are today, we think it is a sector that deserves a key place in a balanced portfolio”.


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