In this week’s bulletin:
- Greece and the EU remain on a collision course and a strong decision needs be made as soon as possible
- Political issues, rather than fundamentals, continue to drive sentiment
- JPMorgan Chase announced $2 billion of trading losses, affecting banking stocks and increasing the pressure on regulators to clamp down on risk-taking
- There is a large difference between European politics and quality European companies. We hear from St. James’s Place fund managers on this important distinction, and the long-term opportunities arising from volatile markets.
Market volatility continues
- Greece and the Eurozone reaching the end game
- Political issues, rather than fundamentals, continue to drive sentiment
Greece and the EU remain on a collision course. A strong decision needs to be made that Greece either leaves the Eurozone entirely, or accepts the austerity measures to which it originally agreed. There is no middle ground and the pressure to find a solution is intensifying. Equity markets hate uncertainty and political wrangling is clouding the economic progress being made around the world and the improved strength of many companies. Undoubtedly, Greece leaving the euro would see short-term turbulence across a range of asset classes, but it would not necessarily see the end of the single currency entirely. A stronger politically coherent euro could be the result.
Looking beyond the turbulence caused by European politics, last week’s market sentiment was driven by heavy losses incurred by JPMorgan Chase and Spanish banking woes. Global stocks have been through their longest run of losses for six months, while the euro has experienced its longest run of reverses since 2008. Investors tentatively returned to equities late in the week, despite JPMorgan Chase’s $2 billion trading losses, pushing equities higher for two consecutive days. The tone for a week of volatility was set by the elections in Greece and France, as the subsequent political posturing in Athens threatened to unravel the country’s bailout deal, again raising doubts over Greece’s continued participation in the single currency. This situation is likely to remain a short-term problem for equity markets until a compromise is found by politicians. Mohamed El-Erian, CEO of PIMCO agreed. “Simply put, this translates into more fragmented European politics, at least in the short term. A politically disparate Europe will find it even more challenging to reach common ground on a range of important issues. Europe’s election results sound an alarm for European integration and, consequently, the wellbeing of both the region and the global economy. Let us hope that the inevitable short-term volatility is a precursor to a more decisive effort to deal with the problems.”
“Ultimately, there can be no strong Germany without a stable Eurozone; no stable Eurozone without a strong Germany; and no global stability without both. It is time for Europeans to make the difficult longer-term choices that are critical to sustaining and enhancing their regional project.”
Action by the Spanish government to address their own banking problems improved risk sentiment as Spain took a 45% stake in Bankia, while forcing other lenders to set aside new provisions amounting to around €30 billion of capital to protect against bad loans. The upbeat note was further enhanced by US consumer confidence reaching a four-year high, balancing out the impact of JPMorgan Chase’s troubles on the US market. The FTSE 100 Index pared losses for the week after closing at 5,575.5, down 1.4% in total as banking stocks suffered amid speculation of tighter regulation. Among commodity markets, gold’s perceived status as a safe haven took a further knock, retreating to four-month lows below $1,600 per ounce and falling 3.5% for the week. Elsewhere, crude oil and copper slipped further, hindered by weak economic data and a strong US dollar.
JPMorgan Chase suffers huge losses
- JPMorgan Chase announces $2 billion in trading losses
- Banking executives express concern that regulation will be toughened as a result
JPMorgan Chase caused billions of dollars to be wiped from the value of banking stocks, while also increasing the pressure on regulators to clamp down on risk-taking at financial groups. The value of JPMorgan Chase fell more than 11%, more than $10 billion, and had a significant effect on Goldman Sachs, Citigroup and Morgan Stanley as investors troubled themselves over the possible impact on other institutions. Speculation increased that the bank may lose more money as traders tried to identify whether the company was still linked to derivative positions. Jamie Dimon, the chief executive, had previously succeeded in distinguishing JPMorgan Chase from the competition on Wall Street by concentrating on managing risk; with the result that deposits with the bank had been boosted by over $400 billion in the last five years. Investors recognised it as the safest of the major US full-service banks. Given the reputation forged over recent years, it is perhaps even more difficult for investors and regulators to understand how such a situation was allowed to occur.
Regulators were investigating the JPMorgan Chase losses from trading credit derivatives in its chief investment office. Rival banking executives expressed concern that rules governing trading would be tightened in the aftermath, worrying that US politicians may look to make political capital out of the announcement. JPMorgan Chase has thus far refused to explain how the strategy went awry, presumably because it still holds some of the loss-making positions and is afraid of allowing rivals to take advantage of the situation. Critics have cited the news as evidence that investment and retail banking operations should be split, but bank sources have warned that the plans by the UK and US would not have prevented the $2 billion loss. All retail banks have a treasury department tasked with hedging risk, just like the operation at JPMorgan Chase. Nevertheless, we believe that further tightening of legislation around the banking sector is inevitable.
Shocks create opportunity
- It is important for any long-term investor to recognise opportunities that arise from volatile markets
- There is a large distinction between European politics and quality European companies
The weekend press was awash with debate over how investors can cope with the market volatility caused by the ongoing Eurozone problems. All offered different solutions, with certain sections of the media still highlighting gold as a safe haven, despite the argument that a ‘safe haven’ asset should not fluctuate sharply in price in relatively small periods of time. Julian Jessop, Chief Global Economist at Capital Economics, agrees:
“Gold is now behaving like a risky asset. This can be seen in the unusually high correlation in daily prices of gold and European equities. A low or negative correlation should be a key characteristic for a safe haven.”
Diversification across asset class and geographical region remains the essential tool to reduce volatility within any investor’s portfolio; we have always advised clients to hold any short-term liquidity funds in cash to enable them to take a longer-term view with their growth assets. It is difficult to predict short-term fluctuations, especially when these movements are based on political wrangling and investor sentiment, but volatility does not need to be feared by a long-term investor.
Now that the dust is starting to settle on the news that Angela Merkel may not be able to rely on French support, and Greece may decide not to repay its debts, it is important to recognise the potential opportunities that open up. It is also a chance to weigh up exactly what it means for investors exposed to European companies. Stuart Mitchell, manager of the St. James’s Place Continental European funds, opined: “Stripping away the election rhetoric and Anglo-Saxon press hysteria, not very much will change with the election of François Hollande in France. There will undoubtedly be some sort of face-saving deal whereby the stability pact will remain firmly in place, but it will be adapted with some sort of growth pact. This could take the form of a number of infrastructure investments financed by the much-speculated-upon ‘eurobond’. As to his other plans, such as reducing the retirement age to 60, these are impossible to enact while growth remains weak and France remains committed to a balanced budget until 2017. Mr Hollande will also be conscious that markets will be keeping a close eye on his every move. At the end of the day, Europe will probably muddle through. The debt challenge to Europe is, in reality, less severe than those facing the UK and the US. However, the key difference is political. In contrast to more macro-orientated investors, we continue to be impressed by the strength of the corporate sector. Whilst a number of our company meetings have revealed weakening demand in Italy and Spain, this is more than offset by accelerating growth in the US and continuing demand from emerging markets.”
“At a company level, you can buy some of the best multinational companies in the world at 40–50% discounts to their competitors in the US. The only real difference is that their headquarters happen to be located in Europe.”
This is a view shared by Ken Broekaert of Burgundy Asset Management, whose view remains unaffected by short-term news flow. “Nothing has changed as a result of the European election results. Our views on our French holdings [Sanofi, Publicis and Neopost] have not changed at all, nor has our overall sentiment on the European situation as a whole. We are happy owning a portfolio of high-quality global businesses not dependent on European fortunes for their success. More than 50% of the profits derived by our companies are earned outside of Europe, and while the news is unwelcome, it will not affect our long-term focus.”
For equity investors, it is important to understand the nature of the businesses themselves, rather than placing unnecessary prominence on where the company is listed. News flow, both positive and negative, will continue, and the road to economic recovery will be long, but history shows that this is where the greatest opportunities arise. Richard Oldfield, manager of the St. James’s Place High Octane fund, stated: “We feel that the macro-economic dominance will continue for some time, but this provides an opportunity.”
“A company like Fiat SpA, though quintessentially Italian, is in fact a global company with well over half of its profits derived in the US through Chrysler, and 18% in Brazil. However, its share price has been battered by the problems of the Eurozone.”
“We think we are quite likely to lurch from crisis to crisis in Europe but, in the meantime, the window of opportunity in terms of valuations could well be open. It may well take time, but it is still an opportunity. If we knew for sure things would get worse, we would delay investment, but not knowing this, we should take advantage of a level of valuations in the likes of Renault, Fiat and ENI where it is difficult not to see significant returns over the long term.”
Patience is often rewarded
Weak economic growth in the UK, as well as the continued troubles of the European Monetary Union, may well see lower equity returns for investors in the short term. Looking further ahead, equity investors need to focus on the strengths of the individual companies in which they invest. For example, the price/earnings ratio, which takes into account the current share price and the previous year’s earnings, is often used as a guide as to whether a share is ‘cheap’; the lower the number, the cheaper the share. Since 1990, the average price/earnings ratio for the UK stock market has been 17.3; while over the last ten years, it has been 12.9 (source: Capital Economics). At the start of 2012, the ratio stood at 11.7, meaning that any reversion to the long-term average could see significant long-term opportunity. Of course, this is just one guide and there are no guarantees, but whether the subject is Europe or the UK, there are reasons for optimism assuming that investors, at some point, return to judging companies on their competitive strengths.