More QE likely to be announced this week

In this week’s bulletin:

  • T Markets enjoy a relief rally following EU summit
  • LIBOR scandal hits London banking stocks
  • EU summit sees leaders agree raft of measures to help Spain and Italy
  • Bailout fund gets increased firepower
  • Progress towards longer-term fiscal union
  • Double-dip recession worse than thought
  • Bank of England governor blames EU crisis
  • More QE likely to be announced this week
  • European equities may be down but are not out
  • Low valuations offer good opportunities
  • ‘Income for Growth’ strategy works

 

Market Eye

  • Markets enjoy a relief rally following EU summit
  • LIBOR scandal hits London banking stocks

Developed markets enjoyed a relief rally towards the end of last week, thanks to agreement reached at the latest EU summit which allowed stocks to end a disappointing second quarter on a positive note. But investors endured another rollercoaster ride in the run-up to the summit as the bulls and bears fought for ascendency driven by speculation that a deal would be struck to help two more of the eurozone’s ailing members, Spain and Italy. As it transpired, a deal was forthcoming and we discuss the ramifications later on. The improved sentiment enabled the London stock market to overcome the latest scandal to hit the maligned banking sector which involved the manipulation of the benchmark lending rate, LIBOR. Despite a rally by the euro, currencies generally trod water; but in the commodity markets, gold, silver and oil all advanced with the price of Brent crude jumping almost 10% on renewed hopes about global growth prospects. Greater optimism meant that demand for the safe havens of gilts, Bunds and US Treasuries abated somewhat, leaving yields little changed on the week.

 

Another Quick Fix?

  • EU summit sees leaders agree raft of measures to help Spain and Italy
  • Bailout fund gets increased firepower
  • Progress towards longer-term fiscal union

The latest EU summit was the 19th in a string of meetings that started around 18 months ago, all charged with the same objective to fix the eurozone sovereign debt crisis once and for all. Given the fact that Europe’s political cycle is out of kilter with the economic one, it has been no surprise that EU politicians have failed to take the necessary tough decisions as quickly as the international bond markets demanded, hence the considerable volatility in financial markets which have become the norm over the last 18 months. Previous summits have been characterised by much political posturing and rhetoric, often culminating in piecemeal actions in an attempt to patch up what were clearly serious problems in the eurozone peripheral states. So has the latest summit made any real progress?

In the run-up to this EU meeting, the agenda included half a dozen likely, short-term, measures that, at best, would give more time for the likes of Angela Merkel to persuade her own electorate that the country was not throwing good money after bad. However, in addition to these measures, two further potential options were included that would genuinely offer the prospect of long-term resolution to the debt problem. These short-term actions included the direct recapitalisation of Spain’s (and possibly others’) banks and a banking licence for the European Stability Mechanism (ESM) that would give access to European Central Bank (ECB) funding and thus greatly increase its firepower. Also on the list was: ending the seniority of official loans to Spain over other creditors, which had threatened to alienate private investors, thus exacerbating the problem; banking supervision by the ECB; buying Italian and Spanish bonds to reduce their borrowing costs; and lastly, a growth pact that would involve issuing project bonds to finance infrastructure spending.

The two long-term solutions involve moves towards a banking union and a single eurozone bank deposit guarantee scheme and, crucially, the introduction of eurobonds or eurobills: that is, the common issuance of debt by the eurozone that would involve cross-subsidy by richer states and help lower sovereign borrowing costs. This last policy is the one that Germany has forcefully resisted, saying it would only contemplate such action if it also included full-blown fiscal union.

So how did this summit score in terms of progress? Well, starting with the last policy suggestion, the answer is still ‘No’, it seems; although Angela Merkel was forced to concede some other significant changes which undeniably will help both proposals in the short term and also set in place a pathway to this more fundamental policy change. The key areas agreed on include allowing the ESM to intervene and aid banks directly; specifically Spain’s at this moment, which will see anything up to €100 billion in cash injections. This is a crucial difference because the original plan was for the bailout funds to be channelled via the Spanish government, meaning Madrid would have added to Spain’s already burgeoning debt burden. In a further concession, loans for Spanish banks will be treated as equal to all others, meaning EU governments will not be allowed to jump the repayment queue. The ESM will also be allowed to buy sovereign bonds – particularly those of Spain and Italy – at auction; but this time the help would come with lighter conditions. The final measures were included in the announcement that EU leaders had also agreed a €120 billion ‘growth pact’ and the start of negotiations towards closer fiscal and economic co-operation.

And so for the crucial question: has this summit succeeded? Well, if measured by the reaction of the financial markets, then the answer seems affirmative. Equities in Europe and on Wall Street have rallied strongly. Yields on Italian and Spanish bonds have fallen sharply, so reducing the pressure on their respective government’s borrowing costs. Whilst it would be premature to jump to conclusions, the latest rally has, unlike previous ones, not fizzled out within the first hours, implying the markets are at least taking the latest series of policy changes more seriously. Whilst there is still some scepticism about success in the longer term in some quarters – Angela Merkel faced a backlash from the Bundestag on Friday with lawmakers demanding an explanation for the Chancellor’s U-turn – there are also reasons to be hopeful. Looking at the big picture, the eurozone as a whole is in better fiscal shape than the US: both its general government net lending and net debt as a percentage of GDP are lower than America’s. US net debt is around 90% of GDP compared to the eurozone’s 70% and the region could, as a whole, benefit from the low interest rates the US enjoys, which would boost growth prospects. So for now, whilst there is clearly still work to be done, eurozone leaders have shown that progress is possible.

 

UK Economy Struggles

  • Double-dip recession worse than thought
  • Bank of England governor blames EU crisis
  • More QE likely to be announced this week

Here at home there is increasing evidence that the slowdown in the economy has been greater than at first anticipated. Official figures released by the Office for National Statistics (ONS) last week showed that the economy shrank by 0.7% in the six months to March – slightly worse than originally estimated. Optimism that second quarter figures – ONS data will not be available for some weeks – would be better has dimmed, following weaker manufacturing data. The government has been relying on the private sector to take up the slack as a result of planned government spending cuts; but it transpires that the economy would have shrunk further were it not for the fact that, despite austerity measures, government spending has actually risen over the period. However, economists argue that relying on central government spending to continue lifting growth is not sustainable longer term.

Much of the setback can be attributed to falling confidence as a result of the worsening eurozone crisis. Last week Sir Mervyn King, Governor of the Bank of England (BoE) warned that Britain’s economic situation had deteriorated significantly in the last six weeks and cautioned that a sustainable recovery was unlikely until after the eurozone crisis was resolved. Observers believe Sir Mervyn is paving the way for another dose of stimulus in the form of quantitative easing (QE) to be announced this week when the Bank’s Monetary Policy Committee (MPC) convenes midweek. He said last week that the BoE had “not run out of road” with QE, even though he accepted it might not be sufficient to build a self-sustaining recovery; so the market consensus is for the BoE to announce a third round of QE, likely to be in the region of £50–75 billion. The BoE uses the injection of new cash to buy gilts that, by pushing up prices, keeps yields and also corresponding borrowing costs low. It has already purchased £325 billion of stock since March 2009. The MPC will announce any changes to interest rates – unlikely – together with any new QE on Thursday.

 

Investor Strategies

  • European equities may be down but are not out
  • Low valuations offer good opportunities
  • ‘Income for Growth’ strategy works

Notwithstanding the problems in Europe, there are still many European-based businesses that are actually doing very well, as fund manager Nigel Waller, of Oldfield Partners, pointed out last week. “European equities, for obvious reasons, are trading on low earnings multiples yet, individually, many are successful global businesses. Within our global portfolio we own two European businesses that might seem very unlikely given the economic difficulties of the region: Renault and Fiat. The latter is a company we have owned in the past and made good profits from and recently bought back into the stock after selling last year. It is a good example of a business where the sum parts are worth more than the whole company’s valuation. Fiat owns Ferrari and Maserati, both high-quality, luxury brands which are in demand, very profitable and listed in their own right. Yet the market has effectively ignored these assets. It’s true that Fiat’s productivity in Italy is very poor – its factory in Poland has a productivity rate nine times that in Milan – but the company is addressing this and we see considerable upside in this stock. So whilst I can understand investors being very wary of Europe and perhaps expecting fund managers to stay clear for now, the reality is that there is some extraordinary value to be had at today’s prices.”

So with financial markets having been volatile for so long, it is important not to lose sight of the need to have a longer-term strategy in place. Market behaviour over the last eighteen months has been driven by so-called ‘risk-on, risk-off’ behaviour as speculators switch from the havens of government bonds (specifically Bunds, gilts and Treasuries) into equities and vice versa, depending on daily newsflow. A balanced portfolio with an income bias has been a successful approach over the medium to long term, helping to smooth short-term spikes in the markets and, as such, remains a sound investment strategy.

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