Who wants what from the summit?

In this week’s bulletin:

  • Despite a volatile week, stocks closed the week on a positive note amid hope that Europe’s efforts would work.
  • Attention continues to be on the eurozone summit in Brussels, intended to provide a solution to the crisis in bank funding.
  • Who wants what from the summit though? Many major nations have their own agendas, including the UK.
  • Neil Woodford provides his thoughts on the current economic conditions and provides an insight into why he believes that there are still opportunities in blue-chip companies.
  • There are significant events ahead this week with major bond sales in the eurozone and the latest inflation figures from the UK.

 

Market eye

Stocks closed out the week on a strong note, trading higher amid the hope that the macro picture might improve as a result of Europe’s efforts to shore up its precarious financial and economic situation. Meanwhile, cooler inflation in China could mean that the country can curb prices without sacrificing economic growth. In the UK, the FTSE 100 closed down 23 points for the week at 5529.21, on the back of a strong rally by banking stocks on Friday afternoon. Lloyds, RBS and Barclays all reacted well to European Union leaders’ attempts to thrash out a deal and David Cameron’s refusal to entertain a tax on financial transactions.

Europe remained the primary topic of trade; and the region’s major bourses bounced on news that eurozone officials had agreed to tighter fiscal controls. There was also the announcement that funds will be made available by the International Monetary Fund for use in the rapid deployment of the European Financial Stability Facility. Given the dysfunction that has been displayed so often during recent months, the eurozone summit was generally regarded as a step in the right direction, which helped drive the Euro Stoxx 50 more than 1% higher; but the euro currency only gained slightly, perhaps signifying the long road ahead. Hopes were further bolstered by improvements in the borrowing costs of Italian and Spanish debt, which ended the week at 6.33% and 5.71% respectively, having been around the 7% pressure point in recent weeks.

The results of the fourth round in 18 months of European Banking Authority stress tests pointed to a €115 billion capital shortfall, with German banks showing the most notable deterioration in their core capital ratios. Moody’s, the US ratings agency, downgraded three French banks, Crédit Agricole, Société Générale and BNP Paribas due to “liquidity and funding constraints”. The downgrade came despite the agency acknowledging that the lenders could rely on increased French taxpayer support in future.

 

Who wants what?

Attention continues to be on the Brussels summit (the seventh summit of the eurozone crisis, and seventeenth since the financial crisis began in 2008), intended to solve the crisis and deliver a solution to concerns over bank funding.

So what exactly does each member of the eurozone want from this particular summit? It seems like all the media focus is on Germany and France, the traditional powerhouses of the region, but there are many other nations wanting a say. Chancellor Angela Merkel and President Nicolas Sarkozy have called for treaty changes to be signed by all 17 eurozone members by March. They want a balanced budget ‘golden rule’ adopted by all, with an agreement of immediate trade sanctions if deficits exceed 3% of GDP, as well as harmonisation of corporation taxes and a tax on financial transactions. This will lead to years, perhaps decades, of severe austerity measures and falling living standards for certain nations, unless these countries leave the eurozone and effectively return to a devalued currency.

Although they do not get coverage in the mainstream media, relative to the larger nations, there are currently four other member nations with a AAA-rating and each are keen that there is a swift decision. Austria, Netherlands, Finland and Luxembourg are all wary of a ratings downgrade that would increase the cost of their borrowing, with the Dutch and the Finnish particularly vocal in support of tougher sanctions on rule-breaking states. The Dutch have even argued for a Brussels commissioner to have the power to expel member states if necessary.

Two countries opted out of the euro but still want a significant say in how it is managed. Both the UK and Denmark want minimal changes to the treaty, with David Cameron stating that the more the country is asked for, the more it will ask for in return, and any treaty signed by the UK would need to go through Parliament. The prime minister is under pressure for a referendum on the EU and repatriation of power from Brussels, and is massively concerned the proposed Tobin tax (a tax on financial transactions) will negatively affect the City of London. The City could still be exposed to more restrictive regulation. To enact this, at present it is unclear whether a unanimous vote will be needed or whether legislation can be introduced with a simple majority, but David Cameron has in effect delivered a massive vote of confidence in the UK’s banking and financial institutions, risking his own European reputation for their cause.

 

Cheap to borrow 

On Thursday the President of the European Central Bank (ECB), Mario Draghi, announced a barrage of new measures to help contain the credit crisis and to limit the risk that the provision of credit to the wider economy could be hampered by the resulting strains. In parallel, the ECB announced a 25-basis-point cut in its key policy rate, in line with market forecasts, to 1%. This has made it easier for banks to borrow funds, perhaps making a short-term crisis less likely. Market participants were hardly surprised that the ECB cut its target lending rate, but there was a negative response to news that the vote was not unanimous and that the ECB became more cautious in its economic outlook. One surprising issue was that there was a refusal to allow the ECB to enter the bond markets on a significant scale to shore up the weaker markets. Originally, this seemed to be the other half of the Merkel/Sarkozy strategy.

On the same day, the Bank of England’s Monetary Policy Committee (MPC) announced its decision to keep its key policy rate unchanged at 0.5%. Likewise, the size of its asset repurchase programme has been kept at £275 billion; but given that the latest asset purchases are yet to be completed, with only £40 billion released so far, this is unsurprising. There is a fear within the MPC that quicker asset purchasing would distort markets. According to Capital Economics, it is expected that further quantitative easing will be required, possibly as early as February, and that QE will reach £400 billion over the course of 2012, with the MPC starting to buy assets other than gilts.

 

“Potential to make very healthy returns”

It is slowly coming to light that many private companies are actually better off than many governments, and while there may well be a long struggle ahead for many sovereign nations, opportunities abound for equity investors taking a long-term view.

One of the most high-profile fund managers in the UK, Neil Woodford of Invesco Perpetual, manager of several funds for St. James’s Place, recently gave his views on the opportunities in the UK stock market:

“Of course, the eurozone crisis has grabbed centre stage, but it’s often easy to lose sight of what is happening economically when the headlines are focusing on political issues. Fundamentally, much of what we are seeing now is what I have been saying for a long time, which is that this is the aftershocks of the Lehman Brothers collapse and the banking crisis of 2008. The Western world has enjoyed a standard of living that it now cannot continue to enjoy. We have financed the growth in living standards on the back of growing levels of debt. It’s time to pay it back and the consequence of this will be consistently low growth and the burden of this debt weighing heavy on Europe, North America and the UK. The silver lining in this rather dark economic cloud is that many businesses will continue to prosper in this environment and they have been reduced to ludicrously low valuations. Within the equity asset class, there are blue-chip companies with great balance sheets and cash flows. These could be the new sovereigns, but with potential to make very healthy returns.”

With the eurozone issue potentially hanging over us for years, Neil still believes it possible to identify opportunity for investors. “Where the portfolio is concerned, you can’t insulate against the economic backdrop, which manifests itself in many ways. However, you can identify businesses where consumers will continue to spend in a non-discretionary sense. I’ve lived through a number of recessions in my career and it’s clear it is the likes of the pharmaceutical, tobacco and utilities sectors that have performed well during such times and the added attraction is that these stocks are undervalued at present. However, avoiding anything consumer-facing would be a mistake because the consumer will continue to spend vast amounts of money on certain goods and services, and there will be businesses which will increase their market share in such times.”

Over the past fortnight, the FTSE 100 has enjoyed a strong period on the back of eurozone optimism, which causes Neil some concern. At the time of speaking, the FTSE 100 stood at around 5,600. “In the short term, markets are being driven solely by sentiment, with very low trading volumes. At any given time, the level of the FTSE 100 reflects a level of optimism or pessimism around Europe’s problems. We have seen this on at least four occasions in 2011 and each summit has seen the markets build up expectation that there will be a solution drawn up. This has seen a sell-off after each summit meeting. This summit may well be slightly different, but it will be very difficult for political leaders to deliver on the level of optimism that is currently priced into the markets. Fundamental solutions are not going to come out of any summit, but through a long and protracted process of economic adjustment. What I focus on is the long term. I don’t focus on what’s going to happen over the next few minutes or the next few months, or indeed the next year. So what happens in the short term occupies the headlines, but it doesn’t guide how I invest or why I invest.”

 

The week ahead

In the UK, the latest employment data is released on Wednesday, with expectation that there will be a further rise in unemployment and a fall in average earnings growth: while on Thursday all eyes will be on the updated Consumer Price Index figure; with further increases in utility prices meaning that a fall in CPI inflation is unlikely. Monetary and fiscal policy will both be in focus in the US this week, with Congress expected to spend the last week before the holidays trying to reach an agreement to extend the payroll tax cut. However, there is no guarantee that Congress will be able to bridge the gulf that separates the Republicans and Democrats.

In Europe, the world gets to give its verdict on plans to save the euro, as many eurozone members are set for bond sales this week totalling more than £33 billion. Major sales this week are due from peripheral nations Italy, Spain and Greece, and also from the higher-rated sovereigns such as the Netherlands, France and Germany. The success of these sales, and the effects on the benchmark ten-year yields, will give an important indication of market confidence. The problem for these peripheral nations is not the struggle to bring in more stringent budget packages, as this is already being done. However, the issue is that weaker governments cannot finance deficits at an acceptable rate, with rates in excess of 5.5% far too much to bear. Going into the New Year, the challenge for the eurozone is to force these borrowing costs down, and for the likes of Spain and Italy to be able to borrow on acceptable terms for their budget cuts to be effective.

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