In this week’s bulletin:
- Concerns about global growth saw further monetary easing by the UK, European and Chinese authorities.
- Optimism waned about European leaders’ latest package of measures to deal with the debt crisis but the IMF implored them to implement plans to restore longer-term confidence.
- The end of the week saw the euro hit its lowest point in two years and Spanish and Italian bond yields rise to uncomfortable levels.
- Their economy may be slowing but the Chinese growth story still appears intact.
- Whilst further quantitative easing seems the MPC’s solution of choice for now, the impact on annuity rates and pension deficits continues to underline the need for savers and investors to seek long-term income solutions.
Central banks loosen the reins
Last Thursday was a busy day for central banks around the world, with a burst of monetary easing aimed at shoring up the flagging global economy. With timing that surprised markets, the People’s Bank of China announced an unexpected cut in the headline lending rate – the second in the space of a month – demonstrating the authority’s resolve to act decisively to alleviate concerns over a Chinese hard landing. Having had their thunder stolen, the Bank of England’s Monetary Policy Committee (MPC) was next in on the act, keeping interest rates on hold at 0.5% but announcing an expansion of their asset-purchase facility, otherwise known as quantitative easing (QE). The bank will buy an additional £50 billion of gilts over the next four months, taking the total size of the programme to £375 billion, which equates to about 25% of the UK’s annual GDP or, in other words, £14,000 for every British household. This will take the MPC’s holdings of the outstanding gilt stock to just over 30%. The move was widely expected after recent comments from Governor Mervyn King that he felt the economic situation had deteriorated sufficiently to warrant a change in action.
Finally, the European Central Bank (ECB) announced a cut of 0.25% in its main refinancing rate – the first reduction since December 2011 – taking it to a record low of 0.75%. The bank also cut its deposit rate, which acts as a floor for money market rates, to zero. Whilst confirming that the ECB has taken seriously the recent downturn in indicators of economic activity, the markets reacted poorly to the lack of new liquidity or additional non-standard measures. The ECB President Mario Draghi argued that there was plenty of liquidity in the eurozone as a whole and made it clear he believes the onus for providing more support to the peripheral countries still lies firmly with the region’s governments.
The ECB’s rate cuts further reduced the attractiveness of the euro to investors looking for yield, with the result that the currency suffered its biggest weekly fall all year to hit its weakest level in two years. Judging by their reaction, markets were distinctly underwhelmed by the announcements. Rather than bolstering sentiment, the moves seemed to highlight to investors the precarious nature of the global economy. The lack of debt-supportive measures from the ECB forced Spanish and Italian bond yields higher – the former rising 60 basis points on the week to hover around the (deemed-unsustainable) 7% mark.
This was a reversal of the increased optimism seen at the start of the week, which followed the announcement by European leaders of the latest package of measures to deal with the problems in the eurozone. As the week wore on, doubts crept in about the implementation of the proposals. In Germany opposition remains to the plan to give emergency loans to troubled countries and even Finland weighed into the debate, confirming it was against using the eurozone’s new €500 billion rescue fund to purchase Italian and Spanish bonds on the open market.
Today European leaders will get another opportunity to make some decisions as finance ministers meet; the intention being to announce details of the EU loan to bail out the Spanish banking sector. However, with the ‘troika’ – ECB, EU and IMF – yet to deliver their assessments on Spain, there is a likelihood of further prevarication. Christine Lagarde, the IMF’s managing director, sounded an exasperated lady as she implored eurozone leaders to “implement, implement, implement” plans for a common banking supervisor for the euro area and direct recapitalisation of Spanish banks, but also recognised that greater fiscal cooperation would be needed.
“Other elements are needed and there will be hurdles to implementation. But there is no question that pushing ahead with these coordinated actions will help to restore longer-term confidence in the euro area.”
Christine Lagarde, IMF managing director
Ms Lagarde also signalled that the IMF would this month trim its 2012 global growth forecast of 3.5% and that even that projection was dependent on “the right policy actions being taken”.
At the end of a volatile week, the final signpost for the direction of markets came from the US, in the shape of a report showing slower-than-expected growth in US payroll employment. The 80,000 rise in June follows increases of 77,000 in May and 68,000 in April compared to an average gain of 226,000 seen in the three months to March. The news divided opinion on the likelihood of further stimulus from the Federal Reserve. Some analysts believed the figures were not weak enough to affect expectations of QE3, whilst others felt action from the Fed was certain. Attention will now turn to the GDP report for the second quarter and July’s Institute for Supply Management (ISM) monthly service index figure; but many are now expecting Ben Bernanke to deliver on his pledge to provide additional stimulus if the US economy slowed further.
At the end of another week of gyrations, the S&P 500 Index of US companies was marginally down – 0.86%; whilst the FTSE 100 Index added 1.60%. The FTSEurofirst 300 Index rose 1.21% and Japan’s Nikkei 225 was broadly unchanged. Commodities were hit by the Chinese rate cut, with Brent crude oil falling below the $100 a barrel mark to $98.65. The search for safe havens saw German 10-year Bund yields drop 25 basis points over the week to 1.32%; US Treasury 10-year notes fell to end the week at 1.53%.
Signs of cracks in the China story?
The move by the People’s Bank of China came before a raft of economic data this week, including the second quarter GDP estimate, expected to show signs of weakening growth. However, anticipated growth of around 7% year-on-year are numbers of which the Western world can only dream Policymakers are trying to tread a thin line of wanting to expand credit while preventing the re-emergence of speculative property investment.
What China wants to avoid, and what the rest of the world can ill afford, is a hard landing for its economy – a sharp decline in growth or even outright recession after a period of rapid expansion. But how likely is that? The rise in consumer spending appears to be unabated. China’s retail spending was less than a third of that in the US in 2007 but has tripled in size since then. Many women from the ‘one child policy’ era are now in their late twenties, still living at home with parents or grandparents and spending all their salary. China has overtaken the US as the biggest car market in the world and now accounts for 25% of global vehicle sales; 18.5 million cars were sold last year and that figure is expected to hit an incredible 30 million a year by the end of the decade. It is small wonder that BMW’s sales in China increased 37% in the first quarter of 2012 but it’s eye-watering to learn that the average age of Chinese Lamborghini owners is 28. The Chinese economy may be weakening and a further round of monetary easing is likely to be needed later this year, but its role as the engine of long-term global growth appears undiminished and the consensus seems to be that a hard landing will be avoided.
QE3 leaves the docks
The MPC’s announcement of further gilt purchases reflects a combination of easing inflation fears and rising growth concerns. Expectations are that there will be more to come towards the end of the year. Whilst intended to get the recovery back on track and help the government meet its target inflation rate of 2%, attention is increasingly being focused on how the knock-on results are affecting consumers, particularly savers and those approaching retirement. Annuity rates are based on gilt yields and have fallen significantly since the first round of QE in March 2009. QE effectively reduces the number of gilts on the market and pushes up the price of those that remain, thereby reducing their yields and the amount of annuity income a pensioner can buy. Similarly, falling gilt yields exacerbate the deficit problems facing the UK’s final salary pension schemes, already standing £312.1 billion in the red at the end of June, according to the Pension Protection Fund.
So QE is the chosen path for now, but the potential remains for the MPC to widen the scope of its stimulus next year. Widening the range of assets bought to include corporate bonds or securitized small company loans is one option, as is a further cut to the bank base rate; the interest rate futures market is already pricing in a decent chance of a 0.25% cut. That would indeed come as a further blow to savers struggling to combine their risk-aversion with the need for income that beats inflation. The extent of the problem was revealed in data published last week by the Bank of England which showed that £723 billion is currently held in fixed- and variable-rate savings accounts – the highest level since September 2010 – yet average interest rates have fallen from 2.12% to 2.03% over the last 12 months (Source: The Sunday Times, 8 July). Taking inflation into account, the average real return since May 2011 has been -0.98%. In other words, savers have lost £6.9 billion in spending power. In a similar vein, fixed-rate accounts worth about £94 billion are set to mature in 2012 (Source: The Times, 7 July), presenting a challenge for those wanting to reinvest the proceeds. It is estimated that savers who have already ploughed their maturing money into new accounts this year have lost £124 million in interest due to the lower rates now available.
All too often savers do not monitor their savings on a regular basis. With the average instant access account paying just 1.07% (Source: The Times, 7 July), avoiding being switched into a default account on maturity is an important discipline. Alternatively, many are recognising the need to take a little bit more risk to get a better income stream, particularly those looking to supplement their retirement. Investors’ flight to the perceived safety of bonds has meant that yields have fallen and made shares look increasingly attractive for income seekers. Whilst high-dividend stocks in some markets look expensive relative to growth stocks, they are still cheap relative to bonds.
Volatility will remain a feature of markets and there will undoubtedly continue to be bumps along the way. Cash remains the ideal home for money that might be needed in the short term, but beyond that a diversified portfolio that includes corporate bonds, property and higher-yielding equities looks set to provide the best opportunity for inflation-beating income and the scope for an ‘income for growth’ strategy.