In this week’s bulletin:
- Wall Street leads market falls as investors quickly turned their attention from Obama’s election win to the impending ‘fiscal cliff’.
- European Commission downgrades its eurozone growth forecasts as Greece votes through more austerity cuts to secure bail-out funds.
- Chancellor boosts public finances by transferring £35 billion from the Bank of England’s QE fund. MPC keeps interest rates on hold for the 44th consecutive month.
- Outlook for dividend income provides some comfort to struggling savers.
- Wall Street falls as Obama’s election win increases chance of stand-off with Republican-controlled House of Representatives over impending ‘fiscal cliff’
- Better-than-expected data point to improving Chinese economy and reduce the risk of a ‘hard landing’
News that Barack Obama had secured a second presidential term may have brought cheers to the Democrats but on Wall Street the reaction from investors was less welcoming, with the blue-chip Dow Jones Industrial Index plunging almost 500 points in two trading sessions. Unsurprisingly, global equities felt the fallout as investors temporarily headed for the sidelines, preferring instead the safety of highly rated US and German government bonds. Whilst the election outcome was probably no real surprise, there had, it seems, been hopes that the winning party would have a clear majority in the House of Representatives, enabling a swifter resolution to the impending US ‘fiscal cliff’. But as it became clear that Mr Obama’s comfortable victory had not been replicated in the House of Representatives, the markets realised that there is now an increasing risk of a drawn-out stand-off over the automatic spending cuts and tax increases due to come into force at the start of next year. Failure to reach a deal will mean fiscal tightening equivalent to 4.0% of US GDP growth, sufficient to push the economy into recession, with all the associated ramifications.
“The same people that took the US to the brink of a government shut-down and technical default in 2011 will be the ones responsible for dealing with the fiscal cliff”
Chris Iggo, CIO of Fixed Income at AXA Investment Managers
Ahead of discussions though, a re-invigorated President Obama set out his stall by saying that his winning mandate included his policy to oppose favourable tax breaks for the rich and that everyone must share the burden of reducing America’s huge budget deficit. So, against this backdrop, it was inevitable that equity markets would lose ground as investors fretted over the uncertainty this will cause, even though it is almost inconceivable that America’s law makers will not hammer out a compromise package. We share this view. Most major stock market indices suffered falls of 2–3% as a result, with Asian markets leading the way, perhaps somewhat surprising given better economic data from China. Official figures from the country’s National Bureau of Statistics showed that in October figures for industrial production, retail sales and fixed-asset investment were all ahead of expectations. Economists have been worrying that China’s controlled slowdown of its giant economy might overshoot, resulting in a so-called ‘hard landing’ where growth falls sharply to 3.0%. As it stands, the IMF is forecasting the economy will grow by 7.8% this year – much in line with the government’s stated target in the current five-year economic plan of 7.5% – and the latest data should help assuage concerns that the country is on track for a hard landing and that future growth prospects remain intact.
Brussels sees red
- European Commission downgrades its forecasts for economic growth – German powerhouse now being affected by eurozone slowdown
- Greece votes through more austerity cuts to secure €40 billion bailout fund
The weaker tone in equity markets was not, though, solely attributable to America’s deficit problems. Similar concerns exist over the eurozone and particularly after last week when the European Commission (EC) took a red pen to its economic growth forecasts for the region next year. Having previously forecast a small contraction of 0.1% this year, the EC now expects the region to shrink by 0.4%, with growth flatlining next year and growth of 1.4% returning in 2014. The weaker numbers are being blamed on fierce budget cuts by European members that are likely to stifle growth. Mario Draghi, President of the European Central Bank, commented, “Unemployment is deplorably high. Overall economic activity is weak and it is expected to remain weak in the near term.” Whilst the EC expects Britain to grow by only 0.9% next year, this is healthier than expectations for the eurozone as a whole, including Germany. The latter has enjoyed strong growth and unemployment has remained low compared to its southern neighbours. But Mr Draghi suggested that, whilst Germany has been insulated so far, the latest data suggest the slowdown is now starting to affect the eurozone’s powerhouse. Germany achieved growth of 4.2% in 2010 and 3.0% last year, but is unlikely to achieve any growth this year. A statement from the economics ministry last week said that “Domestic and foreign demand for German industrial products is declining”; but, despite this evidence of a slowdown, the country’s coalition government agreed to trim spending and cut the government’s net borrowing. The decision is likely to disappoint other eurozone members looking for more radical action to boost growth in the region’s largest economy.
Alongside these concerns, attention was once again drawn to Greece where there are ongoing worries about the government’s ability to implement more austerity policies as a condition of receiving more bailout funds from the EU and IMF. During a three-day national strike last week, riot police faced a barrage of petrol bombs during protests against further austerity measures. However, with little choice, it was no surprise that the Greek parliament has approved the country’s 2013 budget; a package of cuts and austerity measures seen as vital to the government’s efforts to persuade international creditors to unlock fresh bailout funds. The approval, which secured a comfortable majority, comes just days after a separate package of spending cuts and tax hikes over the next two years scraped through the 300-member parliament with a far narrower majority. This latest vote now paves the way for the payment of some $40 billion of bailout funds to Greece and will allow more time for policymakers to work towards longer-lasting solutions, such as fiscal union throughout the eurozone.
- Chancellor boosts public finances by transferring £35 billion from Bank of England’s QE fund
- Decision to hold interest rates for 44th consecutive month adds to misery for savers
Strained government finances and a shortage of income are not exclusive to the eurozone, however. Last week, Chancellor George Osborne raised a few eyebrows when the Treasury announced that it would ‘transfer’ about £35 billion of surplus income being built up under the Bank of England’s (BoE) quantitative easing operations, making it easier for the Chancellor to meet his rules on public finances. QE involves the BoE buying up government bonds to keep borrowing costs low, with the income (or coupons) on these gilts paid to investors (in this case the BoE) by the government. To date, the BoE has accrued the income on its own balance sheet. Aides to the Chancellor insisted that the operation increases the efficiency of government cash management and merely brings Britain into line with other countries such as Japan and the US. The Treasury issued a statement saying, “Holding large amounts of cash in the APF [the BoE’s asset purchase facility] is economically inefficient as it requires the Government to borrow money to fund these coupon payments.” The Chancellor will use his forthcoming Autumn Statement to set out government spending and growth plans, along with an update on public finances. Pressure is building on Mr Osborne to detail future government strategy to deliver more growth; last week, data from the Office for National Statistics showed that industrial production fell by 1.7% in September, its largest monthly decline for over three years. Manufacturing rose by only 0.1% and some economists see this as evidence that the surge in growth in the summer was due to one-off factors such as the Olympics.
Nor is the Chancellor alone in the search for income. Having endured years of low interest rates, savers are still suffering and things don’t look likely to change anytime soon. Last week, the BoE Monetary Policy Committee kept interest rates on hold at their miniscule level of 0.5% for the 44th consecutive month and there is no sign of any increase until the end of 2014, according to the BoE’s own forecast. Low savings rates, once adjusted for tax and inflation, mean many savers are receiving zero or negative real returns on their cash and things look set to deteriorate. After falling to a three-year low of 2.2%, inflation looks set to rise once more this week to 2.4% as recent rises in energy costs feed through. Coupled with this, many savings rates are being cut by leading banks as the government’s ‘Funding for Lending Scheme’ takes effect: banks are now able to borrow money very cheaply from the BoE, which means they do not need to pay such competitive deposit rates to attract funds from savers.
Hunting for income
- Fund manager Adrian Frost of Artemis explains why he is positive about the outlook for dividends
Against this backdrop, it is no surprise that investors are seeking alternative solutions for part of their cash. Adrian Frost is an equity income fund manager with investment house Artemis and he explains how he seeks out income opportunities for his investors. “Firstly, I try to make sure the ‘macro’ aspect has as little influence as possible. If you stop to think about it, there are thousands of economists and strategists trying to predict it, and occasionally they get it right. There’s not a very good predictability record. When you’re looking at cash flows of companies, you want things that are as much under the control of the management as possible, and so that takes you away from the macro variances. So it’s really a stock-driven approach which ends up with geographical diversity on the basis of the stocks’ characteristics rather than the economics.
“When this fund started, the great movement to strengthen balance sheets, lengthen funding lines and to remove that uncertainty from the equation was already well in progress. The corollary of that means that when it comes to dividends, having been very nervous during the credit crisis, companies now have a high margin of safety and balance-sheet strength, which actually underpins dividends. And the second thing is I think all of them have traded more profitably in the years after the credit crisis than they would ever have imagined, so that’s actually added to that balance sheet strength.
“For example, there is a big weighting towards financials in the portfolio. I think some of our investors might be a bit puzzled as to why we find stocks in that part of the market attractive. I think, when you say financials, people immediately think banks but really it’s everything but banks. It is more about companies that were tarred by the brush of the banking crisis, when in fact they were much more solvent. Take the life insurance industry. That went through its real crisis in the early 2000s but then sorted itself out and actually came into this crisis, not in perfect shape, but in much better shape than one could ever hope for. So it’s really those companies where we feel that there is good cash flow, it’s fairly well underpinned, and there are good dividends to be had. The difference here is that these sectors actually have dividends whereas, HSBC aside, for a UK investor there’s not much dividend to be had in banks.
“I think the sort of companies we own will continue to grow dividends. My note of caution at the moment is that they are probably going to be a little bit prudent about just how generous they are to investors. They’ll grow but not as much as they possibly could for the reasons that are perfectly evident when you pick up any newspaper. Who could blame a company for being quite prudent about what they do? But that money isn’t gone forever; it’s there, it belongs to shareholders and in the right environment it will come back to them in due course. I’m perfectly happy that companies should actually pay secure, modestly increasing dividends rather than actually get too excited and then have a hiccup further down the road. If we couch the outlook in terms of the yield and the dividend progression, you are talking about a yield of something over 4.0% and dividend increases of say, prudently, 5% plus. If you look at that compared to the wasteland of returns elsewhere, there’s very little to compare with it. So that’s why I think people will be attracted towards equities. After all, the environment of very, very low interest rates is in some way asking investors to think about taking more risk, and this is in my view a good risk to take.”