Archives for January 2013

Not so Sterling

All three of the major credit rating agencies, Standard & Poor’s, Moody’s and Fitch, have the UK rated at AAA but with a negative outlook.  A fourth, Dagong, a Chinese-owned rating agency, already has the UK at only A+, four notches below AAA.  They have each warned that a failure to reach the government’s deficit reduction targets in 2013, may lead to a decision to remove the AAA designation.  The worse than expected growth of the UK economy over the last two years has produced less tax revenue than expected and meant that reducing government spending has proved more difficult to achieve.  The government looks increasingly unlikely to meet its deficit targets, and the chances of at least one of the agencies downgrading the UK in 2013 are very high.

For Messrs. Osborne and Cameron, this will undoubtedly be politically embarrassing.  When they first came to power, they laid great store on the credibility of their austerity policy with the financial markets and the credit rating agencies.  Since then, they have often sought to justify the policy by reference to the fact that the AAA rating has been maintained to date, while most Eurozone countries undergoing austerity programmes have seen their ratings reduced.  The Labour Party will be able to score many political points, if and when a downgrade occurs.

For the financial markets, and indeed for the economy, it will, however, be of almost no significance.  Markets are rarely surprised by downgrades to credit ratings, as the agencies telegraph their thinking some months ahead.  Both the US and France have already lost their AAA status with at least one of the agencies, and it has had no obvious effect on yields on their government bonds.  Indeed, French yields have fallen sharply since being downgraded.

For countries such as the UK and US, which have Central Banks who are allowed to print their own currencies, there is in fact no doubt that these governments will always repay their debts.  They always have the power to create the money that is necessary to repay any debt denominated in their own currency.  From the perspective of a domestic investor, there is no risk of not being paid back the nominal value of any government bond, and in that sense they should remain AAA.  That is not of course the same thing as saying that these bonds have no risk, since creating a lot of money to repay government bonds is likely to prove very inflationary.  Being repaid in devalued money can seriously damage an investor’s wealth.

For countries inside the Eurozone, matters are very different.  By adopting the single currency, they have forsaken the right to be able to create the money to repay their debts and handed the right to the ECB, who hold a very strong conviction that creating money for such reasons is a very bad idea.  It is thus entirely possible for a Eurozone country to find that it does not have enough euros to pay back its lenders, and thus go into default – hence the crises in Greek, Portugese and Spanish debt markets in the last few years.

One investment implication is likely to be a reversal in the strength of sterling that was seen in 2012, when it was the strongest of the major currencies over the year.  Any downgrade itself is not likely to be the cause of sterling weakness, but both would reflect the poor growth performance of the UK economy.   Further, David Cameron’s recent call for an in/out referendum on the UK’s membership of the EU, will create much uncertainty in the minds of global businesses and investors looking to invest in the UK.  The pound looks set for a period of weakness, and investments overseas should benefit from currency gains for UK investors.

Weak Yen weakens Germany

Germany, the powerhouse economy of the Eurozone, recently announced 2012 GDP growth of only 0.5%, and that it expected 2013 to deliver only 0.4% growth.  At a time when most of rest of the Eurozone is undergoing policies of austerity and reductions in private sector wage costs, they are looking to Germany to be the source of demand for their goods and services, which their own economies are currently unable to provide.

With a balanced budget, near full employment, and a trade surplus of 7% of GDP, Germany is ideally placed to pursue policies designed to boost German consumer incomes and spending, which the rest of the Eurozone could supply.  Yet, aside from some very modest pre-election tax cuts, which have already been announced, there is no indication that German politicians wish to go down such a road.

This is for two reasons.  Firstly, they take the view that the reason for their economic success is precisely because they have not, historically, pursued such short-term stimulatory policies, but have instead concentrated on ensuring they have globally competitive private-sector industries and a structurally balanced public-sector budget.  Secondly, the German Finance Ministry has realised that in the next few years they will need to provide funds to meet their obligations to the EFSF and the ESM, which have been set up to provide the bail-out monies for the weaker countries. They are thus already planning for offsetting public sector spending cuts in 2014 and beyond – in sharp contrast to all other countries, who are hoping further bail-outs won’t be needed, or will seek to borrow the funds from the markets if they are.

So, domestic spending is unlikely to be driving the German economy in the near future.  As usual, Germany will be hoping to benefit from global demand for its exports. Here though, the actions of the ECB and Japan may thwart those hopes.

Despite the Eurozone sliding back into recession, at its last two monthly meetings, the ECB has not cut interest rates when many commentators thought that it could and should have done.  Indeed after the last meeting, Mr Draghi made clear that the ECB had done as much as it could to promote growth, and it was now the role of governments to produce pro-growth policies.  The markets interpreted this as saying that no more rate cuts or easing of monetary policy would be forthcoming, in contrast to the $85bn each month of QE from the Federal Reserve.  Since then the euro has been the strongest of the major currencies, making German exports less competitive.

In Japan, the focus of the new government to stimulate the economy by all possible means including weakening the currency has seen the yen fall sharply in recent weeks.  Against the euro the yen is 20% weaker over two months and 26% weaker over six months.  These are dramatic moves for any major exchange rate, but the euro-yen exchange rate is particularly important for Japan and Germany.  This is because their strengths are in very similar industries, and competition is hard-fought in sectors such as automobiles, power plants and high-technology capital goods.

In early 2009, the exchange rate was 140 yen to the euro, and over the next 3 years the yen strengthened to 95 yen to the euro, making Japanese companies very uncompetitive against European (but most importantly, German) companies. German exports performed very well in 2010 and 2011, particularly to China.  This was also helped by a diplomatic row between Japan and China about sovereignty rights over some small islands lying between their two countries, sparking popular anti-Japanese sentiments inside China, and consumer boycotts of Japanese goods.

Japan is now deliberately weakening the yen further to stimulate their economy – the recent 20+% fall in the exchange rate will be a particular problem for German competitiveness, and will hold back export demand this year.

The investment implications of this are to remain wary of the European economy and light in European shares, to expect the euro to strengthen , and to be heavy in Japanese shares, but to avoid the yen exposure by, for example, owning currency-hedged share classes of Japanese funds.

America’s cliffhanger

The US fiscal cliff agreement, which passed through Congress on the first day of the year, showed most US politicians in a bad light.  Only at the very last minute before significant tax increases and spending cuts would have taken effect, did all participants agree to (i) a deferral of these measures for two months, (ii) a 4.6% tax increase on all incomes over $450,000, and (iii) a 2% payroll tax increase on all incomes up to $107,000.  Obama got the tax increase for the top 1% of earners that he had campaigned for, which will raise about $60bn a year, and the Republicans demanded no further extension of the payroll tax cut, which will raise about $125bn a year.  Together these measures will reduce US consumer incomes by a little over 1% of GDP in 2013.

This was just about the minimum possible level of agreement, and the fact that it took until 1st January to get to that point does not bode well for the chances of securing a more substantial and longer term agreement on government finances ahead of the next fiscal cliff deadline which is now 1st March.  However, several important conclusions can be drawn from recent events:

  1. All US politicians do now understand that the fiscal cliff deadline would have sent the US economy into recession if no agreement had been forthcoming, and that a failure to extend the US debt ceiling would lead to a technical default on US Treasuries with very negative consequences for markets.  Neither side wish to be seen as responsible for either of these events therefore future agreements will likely be made in time.
  2. Markets believe that agreements will always be made in time and so much less inclined to panic ahead of the fiscal deadlines.  Without markets exhibiting any such fear, the politicians have less reason to give ground in the negotiations until the very last minute.
  3. Obama has continued the style of his first term of not being prepared to engage directly with the Republican leaders in negotiations, preferring instead to call them to the White House in order to lecture them, and then leaving negotiations to others in his cabinet.  This is not helping to build goodwill and gather support, making substantive future agreements more difficult to achieve.
  4. Neither Republicans nor Democrats are actually very concerned about the levels of public debt ($16tr, more than 100% of GDP) and the budget deficit ($1tr a year) per se.  The Republicans are essentially opposed to any tax increases, which would tend to harm their supporters, and the Democrats are essentially opposed to any spending cuts, which would tend to harm their supporters.  There is some scope for tit-for-tat concessions here, but getting beyond the minimum acceptable levels to avoid market crises will be very difficult.
  5. This lack of strong commitment to deficit reduction makes it likely that there will be no meaningful austerity in the US until there are difficulties in selling the Treasury Bonds necessary to finance the deficits.  Given the weakness of the European economy following its efforts at austerity, this should support the US economy in the short term.
  6. The policy of the Federal Reserve is currently one of Quantitative Easing of $1 trillion per annum until further notice.  The Fed is providing the markets with enough new money to finance the budget deficit.  Ultimately, such a policy will lead to inflation and a collapse of confidence in the dollar.

The investment implications of the above are that US financial markets continue to be supported, in the short term, by a lack of austerity and continued printing of money, but that in the longer term, these same policies will lead to inflation and a credit crisis. With this outlook, investors should broadly remain invested in company shares, wary of bonds with fixed coupons and insured with gold.