bail-out for Greece plus positive economic data from the US

In this week’s bulletin:

  • Global equity markets continued their gentle upward trend last week with all the major indices edging higher. In the US the S&P500 index exceeded its high of last year which itself was a post-financial crisis high.
  • Sentiment was buoyed by news of a second €130bn bail-out for Greece plus positive economic data from the US and a continued rebound in German business confidence – despite forecasts that 10 of the eurozone’s 17 members will fall into recession this year.
  • The Bank of England’s decision to inject a further £50bn into the UK economy via QE has not been without criticism – we discuss the pros and cons of the programme and what it might mean for the UK economy and investors.
  • This week the European Central Bank is expected to announce the second tranche of its very own QE – its longer-term refinancing operations programme, known as LTRO. ECB president Mario Draghi is likely to announce a second €500bn injection to help EU banks recapitalise on the back of low-cost borrowing over the next three years.
  • The bail-out for Greece comes with huge strings attached for the country – we asked some of our independent fund managers for their interpretation of what the news might mean for equity and bond investors.
  • The one price that is heading in the wrong direction is crude oil. Last week Brent crude hit a record in euro and sterling terms, closing at over $125 per barrel. We discuss the reasons behind the recent rise and the ramifications.

Market Eye

  • FTSE100 closes in on seven-month high
  • Euro rallies as German economy shows resilience

Global equity markets remained quietly firm last week with all the major share indices edging higher. News that Greece was to receive its second EU bail-out – worth €130 billion – was already much discounted and created more rhetoric than anything else. Underpinning confidence were two other key events.  The first was news that China’s Central Bank had cut its reserve requirements for Chinese banks which, although seemingly small at 25 basis points, will effectively be a stimulus worth around $46bn to its economy. The other aspect was further evidence of a pick-up in the world’s largest economy: a combination of good corporate earnings reports and positive economic data from the US housing and labour markets fuelled investor confidence. By the end of the week London’s blue-chip index closed up 0.5%, close to its seven-month high point. On Wall Street the S&P500 index managed to close at a post-financial crisis high, as the 2012 rally in US equities moved up another leg; the index closed at 1,365 – two points higher than its previous peak last April. Meanwhile the heavyweight Dow Jones Industrial flirted with 13,000 on Friday before retreating slightly to close at 12,982.

Elsewhere, the euro rallied, managing to trade at a two and a half month high against the dollar, boosted by upbeat investor sentiment. This was despite data from the region’s powerhouse Germany, that revealed its economy had contracted by 0.2% in the last quarter of 2011. Instead, investors focused on a better-than-expected reading on the closely watched Ifo institute survey of German business sentiment which rose to 109.3, its fourth successive monthly increase. Germany’s resurgent economy contrasts sharply with ten of its co-member states which are forecast to dip into recession, including Greece, Spain, Italy and Portugal. One area of growing concern though for the markets was oil prices – Brent crude hit a record high in euro terms on Thursday after rising to $125.47 per barrel. We discuss the implications of higher fuel costs later on. The only other point of note for investors was the continued selling of the yen, reflecting expectations that the Bank of Japan will announce further monetary easing in the hopes of stimulating the economy.

 

Money, Money, Money

  • Is QE working?
  • Data suggests avoidance of ‘double-dip’

The announcement by the Monetary Policy Committee at the Bank of England (BoE) that it was expanding its quantitative easing (QE) programme by £50 billion to buy UK government bonds has not been welcomed in all quarters of the markets. The BoE has faced some stiff criticism since its initial decision to start printing money back in 2009 – mainly predicated on the notion that it is inflationary. However, given the not insignificant sums involved – some £325bn when complete – it’s worth thinking about the pros and cons of such a policy and the ramifications for investors. The UK’s recent bout of higher inflation can be mainly attributed to three events: the depreciation of sterling in 2008, rising global commodity prices and a hike in VAT. Some commentators have been suspicious that higher inflation has been engineered to help inflate away the government’s burgeoning debt pile. However, the BoE has no influence over global commodity prices or government fiscal policy.

The other aspect argued by opponents is that the Bank’s purchases have had no real impact on the UK economy. Gilt yields, which influence long-term borrowing costs, have fallen sharply from around 3.6% to 2.0% since QE started and have been the equivalent of an interest rate cut for borrowers. However, the propensity of borrowers to repay debt and de-leverage instead is something that is also beyond the BoE’s sphere of influence and highlights the huge headwinds that the economy is currently experiencing. One final criticism is that all this extra liquidity is merely being hoarded by the banks to help them bolster their liquidity shields, thus depriving businesses of much needed capital. The reality, as discussed a few weeks ago, is that banks have lent within a whisker of the government’s target through Project Merlin and cannot be accused of starving the economy of cash. Indeed, UK Corporate plc is actually sitting on record cash piles, preferring to increase dividends for shareholders or buy back its own shares rather than invest in growing its businesses at this point. A report from the Institute of Directors shows that 29% of companies expect to invest less this year than last, marginally more than the 27% who expect a rebound. Among the fears cited as dampening optimism is the eurozone debt crisis.

However, we shouldn’t read too much into these somewhat gloomy statistics because it appears that, after last year’s undeniable economic slowdown, there may well be some of the oft-criticised ‘green shoots’ appearing. Surveys due to be released this week are set to show that the UK has managed to avoid a so-called ‘double-dip’ recession with manufacturing, retailing and construction all expected to show a recovery is underway. Here is a flavour of what is actually going on in the economy: the CBI says that total and export order books are well-above long-term averages, with Britain’s car manufacturers increasing output by 15.6% last month. And exports are going to growth regions – the Engineering Employers’ Federation says that the value of exports to the likes of China is rising more than 30% annually. It seems very likely that, based on current activity, the purchasing managers’ (PMI) surveys published by Markit are consistent with annualized growth of around 0.8%. Perhaps then it should come as no surprise that investors have decided that corporate earnings are likely to remain solid, along with margins, as companies continue to keep a close eye on costs.

 

More from Mario

  • EU takes control of Greek economy
  • ECB injects a further €500bn of cheap money

Last week’s €130bn deal on Greece’s second bail-out comes at a heavy cost. Firstly, banks across Europe revealed further steep write-downs on their holdings of Greek sovereign debt last week, as Athens prepared to impose losses on private creditors through a bond restructuring. Put simply, the latest deal will eliminate €100bn of an estimated €200bn in Greek debt held by private investors. But this aspect was well-known and had little impact – for example, the share price of Crédit Agricole, which wrote off €220m, hardly moved, along with many other banks’ shares. The other part of the burden will be borne by the Greeks themselves. It appears that European creditor countries are demanding 38 specific changes in Greek tax, spending and wage policies by the end of the month. Along with a host of other reforms (allegedly some 90 pages) the EU will effectively be micromanaging the Greek economy for the next two years. It seems that the rescue package goes beyond economic reform, impinging on the judiciary to land registry. So it appears that this time, Europe’s politicians are determined to demonstrate to the markets that the latest deal will not be allowed to be fudged like the previous one and that Greece will conform.

The other worry for the markets has been around contagion. Last year there were fears that if Greece failed, then it would take Italy, Spain et al with it. Fortunately, help came from the European Central Bank in the form of de facto QE but more correctly termed, longer-term refinancing operations (or LTRO). The plan was masterminded by the ECB’s president, Mario Draghi or as he is known colloquially, ‘Magic Mario’. And it’s true to say that the first €489 billion shot of LTRO at the end of last year did indeed work like ‘magic’ for the markets. In essence the ECB allowed some 523 European banks to borrow cheap money at 1% for a three-year period, parking virtually any asset as collateral and thus giving banks time to reduce debt. The effect was indeed remarkable: it averted a credit crunch across Europe and had a dramatic effect on sentiment, enabling many banks to return to the capital markets and issue new bonds. This week will see round two of LTRO, estimated to be as much as €500 billion, which will mean the ECB has injected around €1 trillion into the financial system: not as much as the US Federal Reserve but more than the BoE. Like last time, Italian and Spanish banks are expected to be the biggest users, with the proceeds being invested in government securities, hence why bond yields have fallen dramatically from their highs. No doubt the markets will once again welcome the latest round of ‘Mario’s magic’.

 

A Professional View

  • Significant step towards resolution of debt crisis
  • European companies reporting strong US demand

Events in Europe dominated the markets last year, creating a war of attrition between the markets and policymakers leaving many investors suffering from crisis fatigue. As discussed, sentiment has improved markedly this year, so how do professional investors see the latest agreement impacting on their investment strategies? We asked a number of our fund managers for their reactions. Global equity manager Mark Evans of THS Partners commented, “The agreements to take a private haircut on Greek sovereign debt and proceed with the second tranche of the bailout are significant steps towards the resolution of the European debt crisis. By preventing a disorderedly default and thus reducing the risk of contagion to other euro nations, eurozone policy makers have once again demonstrated their long term commitment to the euro.”

“Given the reduction in systemic risks, we expect to see the discount in

European shares versus their American and Asian counterparts to gradually fall over the course of this year”.

 

European equity manager Stuart Mitchell of SW Mitchell Capital expressed the following view. “As you know, we have remained very positive about the prospects for European markets throughout the ‘panic/wobble!?’ last summer. Despite the repeated anxieties of many commentators about the outlook for the global economy, we could see no sign of this when meeting with companies in Europe. Conversely, we have repeatedly heard that demand from the US is ‘surprisingly strong’. Recent performance in markets would seem to support this view. The Greek deal is pretty much as we expected. The banking sector is easily strong enough to absorb these write-downs. This all gives Greece some breathing room to bring their bloated public sector under control”.

Of course, events in Europe do not just affect equities or indeed government bonds; corporate bonds are also subject to the vagaries of the market so it’s helpful to contrast the equity view. Zak Summerscale of Babson Capital manages one of our corporate bond funds and he made this observation. “The announcement regarding the agreed terms for the second bailout package provided for Greece has significantly reduced the short term threat of default and associated risk of departure from the eurozone. Over the last few weeks, global markets have increasingly been anticipating that this could be the more likely of outcomes. Whilst the steps taken have been positive for markets, we do believe that there are still wider economic headwinds that both global and eurozone economies face. Although the International Corporate Bond fund will not be immune to any wider market volatility, we remain confident that the defensive nature of the Senior Secured asset class continues to provide investors with an attractive High Yielding strategy with strong downside protection as low growth conditions persist. This, against a broader back drop of record low interest rates, continues to make the Senior Secured Credit market an attractive investment opportunity”.

 

High Energy

In a week when oil prices jumped to more than $125 per barrel – the highest since last year’s civil war in Libya – investors’ attention has shifted noticeably from Greece to the potential implications of higher energy prices. Last week, Ian Taylor, CEO of Vitol, the world’s largest independent energy trader, warned that oil prices might rise to $150 per barrel, around the level seen during the 2008 financial crisis. The impact of higher oil costs is clear: the immediate recovery prospects for recovery in Europe are likely to be threatened, with the likes of Greece, Italy and Spain most at risk because of their economic fragility.

The reasons for the recent increase in crude prices might seem self-evident. Rising tensions over Iran’s nuclear programme have led the EU to announce further sanctions, triggering counter-threats by Iran to cut oil supplies. But the rise in prices is not solely attributable to Iran – the risk premium due to Iran accounts for just a few dollars according to JP Morgan – but rather a combination of supply disruption and increased demand lies behind the increase in prices. Disruption in South Sudan, Yemen, Libya and Syria has impacted negatively on supplies. This, coupled with increased demand from Asia and particularly Japan, where power generators are turning to oil as an alternative to nuclear power following last year’s tsunami and Fukushima nuclear disaster. So for now, the capital markets will continue watching events closely to evaluate the potential impact on world growth and corporate profitability.  Against this backdrop, investors should retain a well-diversified portfolio that complements their risk profile and investment timeframe.

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