Anticipation builds over the Chancellor’s Autumn Statement

In this week’s bulletin:

  • Global stock markets enjoy a good week on the back of optimism over the US and China, shaking off news of a downgrade to France’s debt rating.
  • Anticipation builds over the Chancellor’s Autumn Statement as speculation surrounds possible tax increases and cuts in pension tax relief.
  • As pension providers continue to favour bonds over equities to fund future liabilities, fund manager John Wood explains why he sees blue-chip equities as an asset of choice in an era of deleveraging.

Market Eye

  • Global stock markets enjoyed a strong rally last week on better economic news from China and hopes the US will avoid a ‘fiscal cliff’
  • France loses its AAA sovereign-debt rating but investors remain phlegmatic

Financial markets put in a good showing last week, in particular stock markets, where investors got themselves back onto the front foot after the drubbing in recent weeks which saw some of the major indices fall 5% following the US presidential election result. Europe led the way, with both Frankfurt and Paris notching up gains of over 5% – this was perhaps somewhat surprising for the latter given the fact that France’s sovereign debt was downgraded by rating agency Moody’s, removing its AAA rating. Unsurprisingly, Paris denounced the decision but the move came as no real surprise as Standard & Poor’s did exactly the same at the beginning of the year. Elsewhere in the eurozone the IMF and EU continued to haggle over the terms of Greece’s impending €44 billion bailout payment but the markets decided to take a sanguine view of events.

“They are just not looking in that direction. Markets now have the confidence that, when push comes to shove, European politicians will find a solution. That was not the case a year ago.”

Graham Secker, equity analyst at Morgan Stanley

The mood was also buoyed by hopes that the US ‘fiscal cliff’ will be avoided. Positive noises from Capital Hill have assuaged investors’ fears that talks will turn into a cliffhanger. The US Federal Reserve’s Chairman, Ben Bernanke who coined the ‘fiscal cliff’ phrase, took the opportunity last week to raise the pressure on the politicians, saying the problem needed to be tackled swiftly and effectively. In response, Wall Street had its best week since June, despite the market being shut on Thursday for Thanksgiving. Confidence was further boosted following signs that the housing market was continuing to pick up – admittedly from very low levels. Interest rates are at record lows, helped by the Fed’s latest QE programme, where it is committed to buying $40 billion of mortgage-backed securities for the foreseeable future. The net result for borrowers is that they can fix their mortgage for 30 years at a cost of just 3.3%. This has improved affordability and helped sentiment; as a result, home sales and house prices have increased, with both up around 11% over the last year.

Looking East, Japanese exporters continued to benefit from the weakness of the yen and investors also took heart from signs that the Chinese economy would avoid a ‘hard landing’. The HSBC-Markit Chinese manufacturing purchasing managers’ index rose above 50, indicating growth, for the first time in a year. Whilst the likes of Capital Economics believe the data strengthened the view that China’s economy had turned round, expectations remain cautious. “We believe the recovery is patchy. The health of industry is improving but other sectors remain shaky,” commented Mark Williams of Capital Economics. On the geopolitical front, a ceasefire between Israel and Hamas, brokered by Egypt, came into effect – although oil prices remained jittery with the price of a barrel of Brent crude oil rising over 3.0% on the week. Elsewhere in the commodity markets, copper was up, lifted by global growth prospects; and gold rose above $1,750 an ounce for the first time in a month.

Autumn Statement

  • Chancellor under pressure as revenues shrink but expenditure rises – UK faces threat to AAA sovereign-debt rating next year
  • Speculation surrounds possible tax increases and cuts in pension tax relief

It may not be just France that the rating agencies have in their sights. According to one of the world’s top bond fund managers, Myles Bradshaw of PIMCO, the odds are high that Britain may suffer a similar downgrade next year. Mr Bradshaw said the government is heading for the loss of its AAA credit rating and a breach of its debt target in the wake of a fresh deterioration in the UK’s public finances. The Chancellor is currently in the midst of preparing his Autumn Statement due on 5t December, against a backdrop of poor economic growth; for example, corporate tax receipts are down 10% and welfare costs are up 8%; all of which means he has had to borrow some £13 billion more in 2012/13 than was forecast by the Office for Budget Responsibility. It also means that George Osborne’s plan to have debt reducing by 2015/16 is increasingly questionable. But such an outcome should not come as a huge surprise to the financial markets, according to Mr Bradshaw. “The odds that the UK loses its AAA credit rating at some point next year are high but it should not be a huge shock to the markets as it reflects the general deterioration in Western economies’ public-sector balance sheets,” he said. Based on recent experience he is probably right: both the US and France have lost their coveted AAA credit status but it has not impacted on their ability to borrow relatively cheaply from the bond markets. At close of business on Friday, a ten-year US Treasury bond yielded just 1.69%, down from a high of 2.38% a year ago, whilst a similar French bond yields 2.18%.

So the Chancellor finds himself in a tricky situation. On the one hand Mr Osborne is, as said, committed to reducing the UK’s debt burden but equally he is under pressure to stimulate economic growth and put the recovery on a firm footing. At the weekend, business leaders urged him to kick start the economy by giving bigger tax breaks for investment in plant and machinery, which is seen as a quick and simple way to boost the economy. Ministers are hoping that making it easier for smaller businesses to borrow via its Funding for Lending Scheme will also create more jobs and boost economic growth. Conversely, the Chancellor is also eyeing ways to raise more revenue from increased taxes, with higher stamp duty, higher rates of Capital Gains Tax and the possibility of extending Council Tax bands to raise more from wealthy property owners all possible options, according to some experts.

One other area that has caught the media’s attention is a potential focus on pension tax relief. The Chancellor has already made significant reductions in the amounts individuals are allowed to put into their pension schemes, whilst still being eligible for tax relief at their highest marginal rate on these contributions. Currently the annual limit is £50,000 and experts have calculated that cutting this to £40,000 would save the Treasury some £1.7 billion each year in tax relief. The annual allowance on pensions is seen as an easy target as there are relatively few – around 100,000 individuals – who would be directly affected; but indirectly, via final-salary schemes, a cut in the threshold might catch hospital consultants, GPs, head teachers and senior civil servants and not just the very rich. Whilst every Autumn Statement creates speculation about likely changes to policy, it is clear that Mr Osborne is going to have to take some difficult decisions if he is to balance the public accounts and maintain credibility in the financial markets.

End of the Equity Cult?

  • Institutional investors choose bonds over shares, reversing equity ownership trend that began in 1956

“I do not believe for one moment that we are seeing the death of equities.”

Michael Dobson, CEO Schroder plc

Last week we discussed how the demand for fixed income had driven up the prices of both quality government and corporate bonds alike. Behind much of the demand are institutional clients such as pension funds, which buy bonds to match their future pension liabilities. The latest figures from the UK Pensions Regulator shows that, for the first time, final-salary schemes own more bonds than equities, reversing a trend set in motion back in 1956. Despite the numbers, some of the world’s largest managers of pension funds reject the claim that equities are on the wane. Michael Dobson, chief executive of Schroders, which has some £200 billion under management, a large proportion of which is pension fund money, disagrees. “I do not believe for one moment that we are seeing the death of equities. Equities are still attractive for many reasons, whether it is yield, risk returns, or the fact that some are trading on a cheap basis. I always think that when people start talking about the death of something, it often means a revival. We could start seeing people putting money back into equities,” commented Mr Dobson. Others see the changes as an entirely different phenomenon, with investment strategies being impacted upon by the closure of many final-salary schemes and the need to secure fixed streams of income as schemes near maturity. As ever, the most prudent approach for any investor, institutional or private, is to ensure they have a diversified portfolio and to review their strategy in the light of their own investment objectives.

Not Normal Times

  • Fund manager John Wood sees blue-chip equities as asset of choice in an era of deleveraging

Someone else who agrees that we are not in normal times is UK equity manager John Wood of J O Hambro Capital Management. “The global economy is experiencing a ‘balance sheet recession’ and the traditional response is for policymakers to cut interest rates, which is then supposed to lead to recovery. But this approach is not working in the current climate, hence the surfeit of QE from central banks. Resolution of the problem of too much debt requires governments, consumers and corporates to deleverage, which is a structural shift and likely to take a decade plus, based on experience from the last comparable period, the 1930s. This implies it will take until around 2017 before this debt has worked its way through and for a real sustainable recovery to take place. I want to stress though that we are not witnessing the death of capitalism but it will require significant further pain because QE is not working. The liquidity created is finding its way into financial assets but the banks are not lending as they are de-gearing their balance sheets instead.

“The one key counterparty to the current monetary policy in the UK is the government and it too is endeavouring to reduce debt, leaving the BoE as buyer of last resort. The impact of QE has been to make financial markets more volatile, a feature prevalent since 2007. The government needs inflation to reduce the real value of debt it carries so this will remain a threat going forward. Because of this, blue-chip equities are the asset of choice because large companies have pricing power and able to pass on increased costs to consumers, thus enabling them to increase profits and dividends. For deleveraging to work there needs to be ‘debt forgiveness’ which will help recovery. The US has already started this process, with banks writing off bad property loans; this has resulted in the property market beginning to recover, for example in Florida. I believe it will be US consumers who will ultimately lead the global recovery, not China.

“My response to the current environment and challenges it brings is to invest in companies which can demonstrate reliable compound growth, so my top 20 holdings are large corporations which can still achieve volume growth even where there is no GDP growth. Let me give a few examples: Reed Elsevier, Smith & Nephew, Kingfisher, Vodafone and BAT. Stock selection is increasingly difficult with a lack of transparency about how businesses may look in five years’ time, so my universe of choice has shrunk, resulting, for now, in a larger weighting towards cash.

“The crucial choice for me is to try and establish whether a business may be subject to ‘dis-intermediation’. What I mean is, will a company lose its market share to rivals because of huge changes in technology, allowing consumers to go direct, and cutting out a potential provider? Daily Mail Group is a good example – only 18 months ago its regional paper business was valued at c£1.5 billion but this week it has effectively reversed this business into a new company with a value of only £149 million. I have a simple test in terms of a company’s ability and likelihood of being able to stay in business: ‘if it can’t go through the letterbox it can’t be dis-intermediated’. As a consequence of the environment and my approach, I am maintaining the same strategy I’ve followed for the last four years: buying high-quality businesses operating in areas with high barriers to entry, giving them pricing power and leading to a higher likelihood of being able to increase dividends and shareholder value.”

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