Archives for December 2012

2013 – Limited growth and new monetary policy regimes

As 2012 draws to a close, three things about central banks and monetary policy are becoming more apparent. Firstly, central bankers are concerned that they are being expected to fix all the ills in their economies and they believe monetary policy cannot achieve such ambitious targets.  Messrs Bernanke and King have both recently expressed concerns about the limits of what monetary policy can deliver in the face of fiscal austerity.  Secondly, successive doses of Quantitative Easing (“QE”) are generating diminishing impacts on markets and on the real economies.  This is a problem that the Bank of England has recently been highlighting about QE in the UK.  In the US, the recent, and fourth, QE announcement from the Federal Reserve, which will mean over $1 trillion of money printed every year until further notice, saw the US stock market fall on the day, in contrast to all previous QE announcements.  Thirdly, Central Banks are exploring new policy targets: in the US tying policy change to the unemployment rate; in Japan seeking to increase the inflation target; and in the UK discussing the idea of a nominal GDP target in place of an inflation target.   As 2013 begins, investors need to take into account the above developments in their investment strategy.

There are two distinct scenarios for 2013.  In the first, economic recovery and job creation continue to disappoint, in which case it appears increasingly likely that governments will tell Central Banks to concern themselves much less about inflation and more about unemployment.  If so, they would be doing this just as the Central Banks are coming to the conclusion that their current policies to boost growth, are not working very effectively.  The results would be monetary policies that are far more inflationary in intent than has so far been the case since the crisis – this would be a significant regime shift for monetary policy.

Investors therefore will need to seek greater protection from the risk of such a regime change.  This requires heavy weighting to assets that would do well in the face of a generalised increase in investor inflation expectations.  These assets would be index-linked bonds and gold.  The performance of company shares in a scenario of rising inflation expectations is mixed – over the long term company profits would be expected to rise with higher nominal growth, but in the shorter term, rising inflation tends to lead to lower valuations.  Conventional bonds would suffer very badly in an environment of higher inflation.  Commercial real estate would, in the very long term, be expected to act as a form of protection against inflation (as rents rise with inflation).  However, a combination of high unemployment and the shift towards virtual retailing is acting as a significant dampener on demand for office and retail space.  Short term prospects for returns are limited to current rental incomes alone.

In the second scenario, where the global economy does improve enough for unemployment to fall at a rate that was satisfactory to policy-makers, the response from financial markets would also be likely to be higher yields on conventional bonds, together with higher company share prices.  Given these two scenarios (of which the first, disappointing growth, is more likely ), the preferred investment strategy is to be at least neutrally invested in shares, heavily under-invested in conventional bonds and heavily-invested in the “insurance policies” of index-linked bonds and gold.

Returns on cash will remain very low in 2013 and in fact are likely to decline further if further monetary easing takes place – the aim of the Central Banks being to over-supply liquidity to the financial system.  Given the exceptionally low yields available on government bonds, it is difficult to imagine a scenario in which they deliver strong returns.  Corporate bonds, which performed very well in 2012 as credit risk perceptions declined, still offer higher yields than government bonds.  However, they no longer have the potential for significant gains from a further narrowing of the yield premium (over government bonds).  Other areas of the bond markets where the yields are still attractive relative to their risks, are emerging market local currency bonds and short duration, high yield bonds in the US.

The Eurozone economy, the UK’s largest trading partner, looks most likely to continue to disappoint next year, and so create problems for policymakers. Its key economic issue (and Mrs Merkel’s favourite trio of statistics) is that it boasts 7% of the world’s population, 25% of the world’s GDP but 50% of the world’s social spending.  This is at the same time as its demographic patterns are about to deteriorate significantly in the face of a very weak birth-rate and a rapidly expanding population of pensioners.  The sense of existential crisis about the euro may have passed for now, following the ECB’s promise to be prepared to act as purchaser of last resort for sovereign government bonds, but the danger for the euro in 2013 is more likely to come from the streets of Greece or Spain, as continued austerity bears down even harder on the public.  The Italian election is also likely to see a strong performance from anti-austerity parties.  The Eurozone enters 2013 in recession, and its financial system woefully undercapitalised.  For Eurozone markets to perform well in 2013, the ECB will need to be seen to be actually printing money – this is still an unlikely prospect, given the deeply conservative approach to monetary policy of many of the ECB members.

The Japanese economy starts 2013 with a newly-elected Prime Minister who campaigned on a promise to stimulate the economy aggressively and have a higher inflation target.  A weaker yen would be enormously helpful to Japanese industry regaining competitiveness, and after a 23 year long bear market, the stock market may finally be in a position to move higher.

The US economy, still by some distance the largest and most important to the world economy, should continue to grow modestly, but not at a rate that is likely to bring down unemployment sharply.  The short term is clouded by fears over the “fiscal cliff” negotiations, the results of which are likely to produce some modest austerity, which, if European experience is any guide, will cause some damage to growth prospects.  Expect a mediocre year for returns from US assets.

The Chinese economy, the single largest contributor to global growth, appears to be seeing a pick-up in its growth rate after the below-target 7.4% report for third quarter GDP growth.  Growth is unlikely to return to the double-digit growth rates seen in the last decade, but should be of higher quality for stock market purposes.  Instead of relying on exports of low-cost labour manufactured goods and state-sponsored investment spending, Chinese growth in the future is more likely to come from satisfying the increasingly demanding Chinese consumer.  China is also in the fortunate position of having considerable scope to ease monetary policy in conventional ways should its growth prospects deteriorate.  These more conventional methods are generally more effective in the face of weak demand, than the unconventional methods that Western Central Banks are currently forced to use.  Asian equity markets are once again expected to be the best-performing region of the world in 2013.

The UK economy remains buffeted by the trends from the European, US and, to a lesser extent, the Chinese economies. The government’s fiscal austerity programme bites a little harder in 2013 than it did in 2012, but the change in Governor at the Bank of England is likely to lead to a wider discussion about monetary policy means and objectives, which may support the UK bond and equity markets better than those of the Eurozone.  Expect a modest year for returns from UK assets and a weaker Sterling following its surprising strength in 2012.

In conclusion, global economic risks are, in our opinion, biased to the downside for 2013. If these risks are realised, the clamour for a policy response will be very great.  The shift from the 2008 conventional policy responses of lower interest rates and higher government spending to the less conventional 2009-2012 policies of QE may well then develop into a shift to very unconventional policies.  These have not to date been openly discussed, but could include such ideas as (i) using QE to buy shares rather than government or mortgage bonds, (ii) using QE to buy foreign government bonds (equivalent to deliberately pushing down the exchange rate), or (iii) pushing new money more directly into the real economy by for example printing money to pay a “citizen’s dividend” in the hope that it would be spent.  These are all theoretical ideas that would normally strike inflationary fear into the hearts of Central Bankers, but may appear next year as the logical next steps in monetary policy.


Review of financial markets performance – 2012

As 2012 comes to an end, a review of the performance of financial markets indicates that it has been (at the time of writing) a relatively good year for returns.  The major equity indices have managed very acceptable gains – the UK 6.5%, the US 12.5%, Europe 13.5%, Japan 10%, Hong Kong 22%.  Asian equity markets, except for China, once again delivered the best returns for global investors.  Government bond yields have moved lower adding some capital gains to the ever-lower income yields, while corporate and peripheral Eurozone government bonds made more substantial gains as credit risk perceptions declined and equity markets rose.

Somewhat surprisingly sterling has been the strongest of the world’s major currencies, gaining 2% against the Euro, 4% against the dollar and 13% against the yen.  With the very substantial proportion of UK stock market earnings generated overseas, this currency strength probably accounts for the slightly weaker performance of the UK market in 2012.  The best performing currency was however gold which is 7.5% higher in dollars, and 3.5% higher in sterling.

And yet, throughout the year, economic growth in Europe, Japan and China has consistently been disappointing with Europe and Japan slipping back into double-dip recessions.  Forecasts of company profits globally are about 6% lower than the levels expected at the start of the year, and European profits much worse than this.  Once again this year demonstrated that correctly forecasting economic growth or company earnings can be of little value in determining movements in asset prices.

The most significant factor in this year’s good returns is that last December there was a great deal of fear in markets that the problems in the periphery would be too much for Europe’s politicians to be able to deal with.  Stock markets thus began this year a little depressed, but rallied quickly in the first quarter after the announcement of two Long Term Repurchase Operations (“LTRO”) by Mario Draghi.  These provided about E1bn of liquidity for 3 years at 1%, which was mostly taken up by banks in the periphery, who were able to use this liquidity to buy their own governments’ bonds at much higher yields.  This generated profits for them and much-needed demand for their governments’ bonds.

After this strong first quarter, markets then gave back the gains in the second quarter as the impact of the extra LTRO liquidity faded and the global economic data started to fall short of expectations.  The Greek election (just) managed to deliver a coalition majority in favour of the bailout and austerity programme agreed with the EU and the IMF.  However the economic and fiscal situation in Spain was deteriorating rapidly over the summer, once again calling into question the survival of the euro.

In late July, Mr Draghi announced his willingness to buy up the bonds of the weaker countries in potentially unlimited amounts, and “to do whatever it takes” to ensure the survival of the euro.  This was openly opposed by the Bundesbank but once markets understood that Mrs Merkel was supporting Draghi, equity markets and the peripheral government bond markets rallied strongly to the end of the year.  Then, in September, Ben Bernanke announced a policy of monthly Quantitative Easing to be continued, initially indefinitely, or following December’s Federal Reserve meeting, until there has been sufficient recovery for the rate of unemployment to fall below 6.5%.

Since the late summer, it has been the policy actions of the ECB and the Federal Reserve that drove the markets higher, even as the economic news across Europe, the US, Japan and China continued to disappoint.

Thus the fear in financial markets, and consequent low prices, at the beginning of 2012, has given rise to the healthy returns from many investments over the year.  The transition from that fear to the more current sense of complacency, together with the poorer performance of the global economy and corporate profits, means that markets begin 2013 at more expensive levels, leaving less scope for gains next year.

Eurocalm before the Eurostorm

That the Eurozone ends 2012 in an apparently stable condition is mainly down to the work of two people. The first is Mario Draghi with his promise of potentially unlimited intervention in sovereign bond markets.  The second is Angela Merkel’s with her summer policy decision that forcing Greece from the Eurozone would be more damaging than keeping it in.

Mrs Merkel over-ruled the Bundesbank on both of these issues, and her steady approach to crisis management leaves her as one of the most popular European leaders within her own party and country.  She has now clearly grasped that, for the Eurozone to survive in the long term, it is necessary to have a much deeper integration of Eurozone countries, which extends ultimately to national government finances, common banking supervision and control, and joint liability for debt. In short banking, fiscal and political union is required to complete the economic and monetary union.  These are not particularly popular positions to adopt, either with the German people or with the other European nations, but they are the logical steps required to ensure the long term existence of the single currency.

She understands that for this to happen, Germany will have to dip into its pockets and provide substantial assistance to the poorer countries in the transition. However, she has not been as explicit with the German people that the financial costs of such policies to them will be very great.  The German people are not in favour of lending more money in bailouts to their Southern neighbours, and they are not in favour of accepting losses on previous bailout monies already granted.  Next autumn there is a Federal election in Germany in which Mrs Merkel would like to be re-elected as Chancellor.  So ideally, from her perspective, there would not be any more Eurozone bailouts before the German elections.

The recent agreement on the next tranche of Greek aid was farcical.  Everyone (Greece, the IMF, the EU and the ECB) is pretending that Greece is not insolvent, merely illiquid and that (based on optimistic assumptions) all will be well a decade from now.  Significantly, Germany has agreed that should Greece be doing well by 2015 in delivering on its budget deficit targets, then they would be prepared to forgive some of their debt.  The truth is that if Greece does not achieve its targets the Germans will be forced to forgive the debt because it cannot be repaid.  The point though is that any debt forgiveness happens after the German elections, when European priorities may once again be more important than domestic German ones..

Southern Europe is now very close to the limits of its tolerance for austerity. The Greek, Spanish and Portugese governments have all told their people that they are on the last round of austerity measures.  With youth unemployment close to 50% in these countries, anti-euro, anti-austerity political ideas are beginning to gain ground.  German leaders still consistently state that austerity in these economies will be necessary if further bailout funds are to be provided, and this rhetoric will not be watered down ahead of the elections.

The other major Eurozone election due by April 2013 is in Italy.  Mr Berlusconi’s withdrawal of support for the technocratic Monti government and his announcement that he will fight the elections on an anti-austerity, anti-German platform are not helpful for the euro. However, it is the honest debate to be having.

The Eurozone begins 2013 in recession, and fiscal policy is being tightened further, except in Germany.  A weak European economy will mean larger budget deficits than planned, and more pressure from the southern economies for bailouts.  This will produce more demands for austerity from the northern economies, with the rapidly fading ability to deliver either.

The stability of current financial markets in the Eurozone will not survive very long into 2013 without a dramatic improvement in economic growth, which is very hard to envisage.  Ultimately, the only solution for the weaker economies is inflation. This can come about either through leaving the single currency or through overturning the Germanic culture, which controls Eurozone economic policy. The former is the more likely solution, and the investment conclusion is to remain very wary of all euro-denominated investments until a more sustainable monetary system is in place in Europe.


Business Investment: The Key to UK Economic Recovery

Sifting through the small print of the Chancellor’s Autumn Statement, which could be summarised as very much a “steady as she goes” story, one finds the breakdown of the UK economic forecasts generated by the Office of Budget Responsibility. It shows that the sector of the economy which is expected to lead the UK economy back towards growth is Business Investment, which further analysis shows is forecast to grow at a compound annual rate of 9.5% from 2014 to 2017.  Over the same period, Household Consumption is forecast to grow at a compound annual rate of just 2.2%.  Of the four key economic sectors that can drive growth, Household Consumption, Business Investment, Government Spending and Exports, only Business Investment is currently in a position in the UK to lead a recovery.  The Household and Government sectors are both suffering from very high levels of debt and pressure on their incomes and are therefore working hard to curtail spending.  The remaining sector is Exports, but with over half of the UK’s exports going to the rest of the Europe, which is expected to fall back into recession in 2013, export-led growth for the UK economy looks a very distant prospect.

The Chancellor announced two new surprise measures in the Autumn Statement to encourage businesses to invest. The first was to cut the rate of Corporation Tax by another 1% to 21% from 2014, leaving it well below the rates set by other western nations, and a tenfold increase in the tax relief granted on investment by small businesses for 2013 and 2014.  This government has consistently sought to reduce the rate of Corporation Tax since it came to power as an incentive for businesses to invest, grow and create employment in the UK.

Though the growth rates have been quite low at 2.9% and 3.8% for 2011 and 2012 respectively, which have not been sufficient to get the economy as a whole moving strongly, Business Investment has in fact been the fastest-growing part of the UK economy.  Businesses themselves cite two factors when asked why they are not investing more.  One is the readiness of the UK banking system to provide loans to finance investment and the other is a lack of confidence in the economic outlook and hence the generation of a sufficient return on any investment. The Chancellor and the Bank of England have worked together to create the recently-launched “Funding for Lending“ scheme, which provides cheap liquidity for banks who will actually use that liquidity for new loans.  In the first two months of the scheme, only £500m has so far been lent out of a possible £80bn, which is disappointing. If this does not improve soon, then the only explanation left for slow investment growth is a lack of confidence from businesses in the outlook for demand.

Most entrepreneurs are natural optimists, always believing and seeking to do more business and make more profit.  In long periods of little or no growth, such as that which is being currently endured, then such optimism can get squashed by consistent economic disappointment. Normally, the dynamics of capitalism mean that in the downturn, loss-making or unsuccessful businesses withdraw from the market.  This shrinks the supply in that industry, so enabling their more efficient competitors to boost their market share and become more profitable.  However, the recent revelation that 1 in 10 UK businesses are zombie companies, which are effectively bankrupt but are being kept alive by ultra-low interest rates and the reluctance of the banks to admit to more bad debts, is disturbing.  This indicates that this normal operation of the free market system in economic downturns is not currently occurring, leaving less scope for more efficient companies to take the opportunities for them to grow.

There are only two strategies that the UK Government can follow to generate growth.  The first is for the Government to use its strong creditworthiness to borrow in the markets and spend the money productively by, for example, building houses and necessary infrastructure projects.  However, if the money were to be spent less productively, it would merely raise the level of public debt that future generations will need to repay.  The second strategy, which is this government’s preference, is to give the private sector every reason to want to invest, and lead the economy back to growth.  To create the required optimism amongst businesses, it would, paradoxically, help if more companies were made to go out of business.  The costs of this though are more jobs lost and more losses for the banks in the short term, before the opportunities for the survivors can improve.