European banks repaying ‘cheap’ loans from the ECB

In this week’s bulletin:

  • UK equity market posts another strong week of gains and is on course for the best January returns in 13 years, whilst the US market hits a 5-year high.
  • Headline provisional GDP figures disappoint but commentators remain positive for an upward revision
  • European banks repaying ‘cheap’ loans from the ECB provides evidence of further recovery in the eurozone’s financial sector


Further optimism drives markets higher

  • UK equity market on course for its best January returns for 13 years
  • Easing concern over the debt ceiling drives the US market to five-year highs

Last week saw further advances across the majority of global equity markets, upholding for now the prediction of many commentators of the “great rotation” that would see a major shift into equities from asset classes traditionally viewed as safer, such as government bonds, during 2013.

Another strong week for the FTSE 100 saw the benchmark index on course for its best January for 13 years. The index moved ahead 2.11% over the course of the week, reaching its highest point since May 2008. Returning more than 6.5% since the start of January, the FTSE 100 has enjoyed its best start to the year since 1989. In Europe, encouraging German economic data and optimism about the health of the region’s financial system helped European stocks rally, with the DAX Index in Frankfurt reaching its highest level in five years.

“The earnings reporting season is now in full swing and things are progressing well for the majority of companies.”

Oliver Wallin, Octopus Investments

In the US, the S&P 500 Index broke through the symbolic 1,500 level for the first time in almost five years. Analysts cited a run of mostly encouraging global economic data, some positive corporate earnings news and easing concerns about the US debt ceiling as key factors behind the continued improvement in risk appetite. In addition, the US House of Representatives voted to temporarily suspend the federal debt limit, soothing fears of further confrontations in Washington – albeit in the short term. More broadly, the rally in riskier assets over the past few months has been underpinned by expectations that global central banks – significantly the Federal Reserve – will keep monetary policy accommodating for some time.

In Japan, the Nikkei recorded its 11th successive weekly advance. A 2.9% gain in trading on Friday did enough to recover previous days’ losses – after the Bank of Japan’s policy moves were deemed insufficient by the market – and saw the index nudge up 0.12% over the week.


Contraction, if not recession

  • UK GDP figures for Q4 come in below consensus expectations

Last week saw the Office for National Statistics announce that UK economic output fell during the final quarter of 2012, down 0.3% on the previous quarter. The latest GDP data do make for some fairly uninspiring reading but is it really as bad as the media would have us believe? Certainly not everyone would agree on the answer to what was probably the most widely asked question last week – is Britain facing the dreaded triple-dip recession?

image003Clearly GDP is one measure of how an economy is doing and a universally accepted one but, writing in the Sunday Times, David Smith explained that it might be worth scratching the surface just a little further. “Those figures, showing a 0.3% fall in GDP in the fourth quarter of 2012, completed a year in which Britain’s GDP did not grow at all. Squaring that away with another measure of how the economy is doing – the 552,000 rise in employment over the past 12 months, the biggest since the boom of the late 1980s – is hard. Squaring it with a 113,000 rise in full-time employment in the September-November period is as challenging.”

Even so, for many, the latest GDP figures – even though they are, at this stage, just provisional figures – make for a disappointing backdrop. But is there more here than meets the eye? According to many, the contraction in Q4 was driven by a decline of 1.8% in industrial production and, within that, a 1.5% fall in manufacturing. However, the real culprits were a 10.2% plunge in mining and quarrying (the biggest drop in 15 years and led by lower North Sea oil and gas production) and zero growth in the huge service sector – now three-quarters of all output – over the final three months of the year.

It could be argued that, on the back of the Q3 figures, there has been something of an overreaction. Whilst the latest GDP numbers aren’t good, the situation may not be quite as bad as the headlines suggest. The poor fourth quarter figures reflect the disappearance of the previous quarter’s boost caused by the Olympics and the extra bank holiday. The volatile performance of the construction sector from one quarter to the next also complicates the picture. Indeed, if the drag caused by the drop in oil and gas production is excluded, along with the impact of the post-Olympic hangover, the UK actually managed to expand 0.3% in the final quarter.

These provisional figures will be revised over the coming weeks and many commentators are expecting the final number to be slightly more positive. Indeed, the consensus forecast had been for negative growth of 0.1%. The chance of a knee-jerk reaction from policymakers is unlikely. The Bank of England’s Monetary Policy Committee was braced for a fall and the Chancellor, George Osborne, suggested on Thursday that a weak GDP figure would not prompt him to change course.


In for a penny

  • Sterling continues to weaken as the dollar and euro gain
  • Euro momentum continues on evidence of ‘normalising’ financial conditions

Whilst currency markets are notoriously difficult to predict, the value of sterling could continue the tumble it took last week if currency forecasters are to be believed. Whilst holidaymakers will no doubt bemoan the impact this could have on their spending power ‘en vacances’, there is an opportunity for investors who invest in non-UK-listed companies or those listed in the UK that pay dividends in foreign currency, including Unilever, BP and Experian. These payments rise in sterling terms when the value of the pound falls.

The prospect of further QE is very much a real one and all three of the main credit rating agencies – Moody’s, Standard & Poor’s and Fitch – have put the UK under threat of a downgrade; both of these factors pose a threat for the value of sterling. The government is unlikely to take much action to stop our currency depreciating; cheap sterling is actually good for the economy. It encourages foreign investment into the UK, makes our exports better value and creates inflation. That, in turn, helps to erode the national debt, assisting George Osborne to achieve his wider policy targets.

Last month, David Bloom, head of foreign exchange strategy at HSBC, described sterling as “the ugliest out of the three ugly sisters” – her siblings being the dollar and the euro. However, equity funds investing in the US and European markets, for example, will receive dividends from the underlying companies in their local currency. Investors with units priced in sterling will enjoy the added boost provided by a weaker pound when those dividends are converted back to sterling.


Balancing the books

  • European banks begin to repay ‘cheap loans’ secured under LTRO schemes in 2011

The story of how businesses have repaired balance sheets, increased efficiency and trimmed costs in the face of the 2008/09 financial crisis is well known. Yet many European banks, particularly those in the beleaguered peripheral states of the eurozone, were forced to increase the amount of debt on their balance sheets through various schemes led by the European Central Bank (ECB) designed to shore up their defences. The ECB started offering cheap money to banks in December 2011. The two so-called Long-Term Refinancing Operations were greeted as a decisive step in restoring confidence in the eurozone’s financial system and led to the ECB ploughing more than €1 trillion into 800 banks across the region.

On Friday, the ECB confirmed that a third of them had pledged to repay more than a quarter of the first tranche of cheap funding they took at the height of the debt crisis. With much lower levels of tension in the market, the need to keep a significant cushion is much reduced. Furthermore, the amount being repaid, which beat many forecasts, was greeted positively.

This positive mood was echoed by Stuart Mitchell, investment manager for the St. James’s Place Continental European fund, who recently spoke about optimism over the increasing stability within the eurozone. “We’re now at a point where the vast majority of the investment community can start to see a way through the European crisis, reflected in the rally of Spanish and Italian government bond yields. The turning point was Mario Draghi [President of the ECB] giving the go-ahead to make unlimited purchases of sovereign bonds – something that he would only do if he was confident that they could repay. We’ve started to see a number of moves, which mark the beginnings of further harmonisation and integration of the European financial system, which will make the whole backdrop to Europe much more robust.”

“We feel that this story has significantly further to run.”

Stuart Mitchell, S. W. Mitchell Capital

Stuart also discussed his views on the European banking sector and explained that he’d been increasing exposure in recent months. “We’ve become much more positive on the banking sector. Share prices have fallen significantly and are at levels not seen for many, many years. Banks have been fairly aggressively cutting costs and are very much deleveraging. Our focus is on the retail banks, rather than the investment banks which have been subject to the most draconian new rules. Key positions in the portfolio are currently BNP Paribas, Intesa Sanpaolo, and Santander. These holdings all share the same characteristics of being dominant retail and commercial banking franchises and all are light on investment banking operations.”

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