Archives for May 2014

Gilts or Kilts

In recent weeks the gap in opinion polls between those in favour and those against Scottish independence has narrowed from about 10% to about 5%. With some months of campaigning still to go, the vote on 18 September looks increasingly likely to be close. What are the likely political, economic and market implications of a Yes vote?

Political implications

  • Negotiating the split. The SNP envisage 18 months of negotiations prior to becoming independent on 24 March 2016. However, they would be negotiating with the UK government and there is a general election due in May 2015 which could easily lead to a change in the governing party or coalition. The outgoing government is unlikely to deem the negotiations as an important priority, and the new government may well have more pressing policy priorities than reaching an agreement with Scotland – the power is biased towards the UK Government in the timing and pace of any negotiation.
  • Impact on Westminster parliament. Should a new government be led by Labour, then they face the risk that after March 2016, with an independent Scotland in place, the Scottish Labour MPs would have no right to vote at Westminster. This could easily deprive such a government of their majority and could lead to a general election or a change in the governing party. Such a scenario gives a very strong incentive for a Labour-led government not to reach an agreement with the SNP. A UK parliament with no Scottish members would mean a near permanent majority for the Conservative party and a clear rightward shift in the political debate in the rest of the UK.
  • EU membership. Under current EU law, Scotland would have no automatic right to become a member of the EU – in theory, it would have to negotiate terms and win a unanimous vote from all the other countries. This is by no means certain as Spain in particular is likely to vote against such a move, given its concern about setting any precedents when its own Catalan people are calling loudly for independence.
  • United Nations. If Scotland were to leave the UK, it would be likely to reduce the global political influence of the rest of the UK. Its permanent seat on the UN Security Council might well be called into question, as it would be the smallest country with that privilege. Even today, with Scotland, the UK is less than 1% of the world population.

Economic implications

  • Currency. All three major UK parties at Westminster have been clear that they would not agree to a currency union with Scotland. In practice, however, they could not stop Scotland from using the pound, though in that situation Scotland would have no influence over the UK’s monetary policy set by the Bank of England. In theory (again), if Scotland were to become a member of the EU then any new member of the EU has to adopt the Euro as its currency. Creating a brand new Scottish currency is also possible, but would create the need for foreign exchange transactions and heavy costs for Scottish businesses.




A negotiated agreement, which created a formal currency union, would allow Scotland to keep the pound and possibly have a Scottish member on the MPC. However, events in the Eurozone in recent years highlight the dangers and effective loss of sovereignty in being a small country in a currency union when there is no fiscal or political union.

  • Banking system. RBS is the largest Scottish bank with a balance sheet of over £ 1 trillion at the end of 2013 (and this has halved over the last 5 years) with capital of almost £60 billion; given the size of the Scottish economy, a Scottish government could not credibly act as backstop should RBS get into financial difficulties again, whereas currently RBS does benefit from being an institution of systemic importance in the UK that the government is committed to supporting in extremis. Scotland’s ratio of banking assets to GDP is 12:1, which is higher than the peak levels seen in Iceland in 2007. It is likely that RBS would choose to relocate its headquarters to London, which would lead to the loss of a significant number of jobs in Edinburgh.
  • Dividing assets and liabilities. Scotland is about 8.5% of the UK’s economy and population. The SNP is claiming just about all of the UK’s North Sea Oil, its major resource asset, since it would lie in Scottish territorial waters, but only expects to take on 8.5% of the National Debt. The UK government might argue that North Sea Oil belongs to the UK today and so be prepared only to cede 8.5% of the resource asset. The stream of revenue from taxation on North Sea Oil is a key source of money to pay for future welfare spending in Scotland, and the SNP’s economic forecasts assume much greater tax revenues in future years than the forecasts of the current UK government.
  • Credit rating. As a relatively small and new country, with a reasonably high initial level of debt, Scotland would be likely to have a lower credit rating than the rest of the UK, even if there were a strong currency union in place; this will increase borrowing costs for Scotland. There is an additional danger that by reducing the size of the UK economy, and with investors implicitly believing that in a crisis the UK would come to Scotland’s rescue, that the UK’s credit rating would in fact be lower as well. Both countries could lose out.
  • Tax revenues. A number of Scottish-headquartered companies have indicated that it may be commercially necessary or desirable to have a UK headquarters for their business outside Scotland, due to all the uncertainties regarding currency, trade, tax, EU membership and regulation. This might substantially reduce the corporate tax revenue to a new Scottish government from Scottish companies.
  • Prices. Many companies in the UK have national pricing policies, which effectively subsidise providing goods and services to less central regions such as Scotland. Tesco have already indicated that they might adopt a national Scottish pricing policy, which would mean higher prices for Scottish shoppers.

Market implications

  • Currency markets. Sterling is likely to be viewed as a less attractive currency, since it may be backed by a smaller country and tax base than it is currently, and would generally carry less weight or influence in wider world affairs. The most likely market response to a Yes vote in the referendum would be for Sterling to fall against the other major currencies, and gilt yields to rise.




  • Effect on business investment. For business, a vote for independence would undoubtedly create a whole range of issues, about which there would be uncertainty and risk. On pensions, for example, there are completely separate EU regulations for pension funds which cover more than one country.  This may require large extra contributions by companies to deal with current deficits.   In financial services, many providers may judge that it would be preferable to be regulated by the FCA alone rather than by both the FCA and a new Scottish regulator, paying extra regulatory fees. Firms carrying out regulated activities might seek to move employees outside Scotland. All such uncertainties would be likely to lead to delays in investment spending by businesses.
  • Scottish bonds. A new market in Scottish government debt would need to be created, and such debt would be likely to trade at higher yields than the debt of the UK. UK government debts are called gilts and any Scottish government debt has already being colloquially labelled as “kilts”.

The possibility that Scotland might vote NO, but with a very small majority should also be considered.This could be the worst possible outcome since the SNP would undoubtedly believe that a second referendum, in say two years, might enable them to get over the line. International investment into Scotland would be likely to be damaged as investors would have no clarity on Scotland’s legal status and the UK government might well believe that it would derive little benefit from supporting the Scottish economy by, for example, relocating civil servants there.

In the long term, both Scotland and the rest of the UK could be viable, solvent, independent but closely allied, political entities – if both existed today, there would be no obvious reason or need to suggest they form one larger country. However, the transition from the current version of the UK to a smaller version would create major political and economic uncertainties that would be likely negatively to affect business and the economy in the short term. The period of negotiations spanning a UK general election is particularly unhelpful in this regard, and the ramifications on Scotland’s relationship to the EU are significant, but extremely unclear.

It is striking that with less than five months until the referendum, how many major unanswered questions there are about what would happen in the event of a YES vote. In no particular order, these are (i) what currency would Scotland use and how much influence would Scotland have over its monetary policy? (ii) would a newly independent Scotland be a member of the EU and on what terms? and (iii) what happens if no satisfactory agreement can be reached in any negotiations between Scotland, the UK government and the EU? Clear answers to these questions would provide a much more satisfactory basis for Scottish voters to make an informed choice.

For now, assuming a NO vote with a reasonable majority, there are no investment implications. A narrow NO vote or a YES vote would be likely to be negative (but not hugely so) for the bond markets and for the currency, but the weaker currency would be likely to be a positive for the stock market. The impact on financial markets would depend on how constructive the UK government and the European Commission choose to be in dealing with the Scottish representatives seeking to create a new country.

Too many bulls; not enough beef

Since fears about the survival of the Eurozone and potential recessionary impact on the world economy reached a height in September 2011, stock markets around the world have performed strongly. For example, the MSCI World Equity Index has risen by 50% in US Dollar terms. However, this global bull market has been almost entirely driven by rising valuations, rather than by earnings growth. Valuations of many equity markets are now back at the high levels seen in 2006-07 and, in the absence of earnings growth offer limited upside for stocks.  We do, however, see scope for valuations to rise in Asia and Japan, and have most confidence in the earnings outlook of Japan and the UK – these markets are our preferred areas for equity investment. Conversely, the European and US markets are likely to underperform on a relative basis over the next few quarters.

The most commonly used valuation tool by investment analysts to analyse shares is the Price-Earnings ratio (“PE”) – the share price divided by the earnings per share (“EPS”) of the company. The lower the PE, the cheaper the share is considered to be. A share price is likely to rise if the company’s earnings grow, or if investors expect increased earnings quality in the future – this is reflected by the PE rising. Over the long term, EPS can be expected to rise in line with the growth in the global economy, while the PE tends to be mean-reverting around long term norms.

Too many bulls

Since 30 September 2011, the point of greatest concern that a collapse of the Euro might trigger an even deeper world recession, the MSCI World index has risen in price by about 50% in US Dollar terms (about 40% in Sterling). The table below breaks this performance down between the change in forward EPS and the change in forward PE, across the different regions of the global equity market.

  Analysis of MSCI Index performance during the 30 months from 30/09/2011 to 31/03/2014
Index Price Forward EPS Forward PE Forward PE Forward PE
  % change % change % change Level on 30/06/2007 Level on 31/03/2014
MSCI Asia ex Japan $ 24.4 2.4 21.5 15.0 11.8
MSCI UK £ 27.8 -12.9 46.7 12.7 13.0
MSCI Japan Y 58.6 38.5 14.5 18.2 13.3
MSCI Europe ex UK € 49.1 -8.8 63.5 13.6 14.3
MSCI US $ 65.9 11.4 48.9 15.4 15.7
MSCI World $ 51.6 2.8 47.5 14.9 14.8

Source: MSCI, Thomson Reuters.


Column A – MSCI Index

Column B – % price change in Index from 30/09/2011 to 31/03/2014

Column C – % change in Index Forward Earnings Per Share (next 12 months)

Column D – 100 x (1+B)/(1+E) – % change in Index Forward PE

Column E – Index Forward PE on 30/06/2007

Column F – Index Forward PE on 31/03/2014




The table shows that the forward EPS (that is the forecast earnings over the next 12 months) of the MSCI World Index rose by only 2.8% over this 30 month period, but that there was a 47.5% gain in the PE, so the bulk of the gain in the index price was due to increasing valuation. This was most marked in Europe, where the PE expanded by 63.5% (though at the beginning of the period Europe was extremely cheap as it was at the height of the Eurozone crisis), and in the US, where the PE expanded by 48.9%. The Asian and Japanese markets, by contrast, have seen the least PE expansion.

Column F in the table above shows the current values (at the end of March 2014) of the Forward PE – the US and Europe have the highest valuations, while Asia, Japan and the UK have the lowest valuations. Comparing the forward PEs today (Column F) with their levels at the end of June 2007 (Column E), the valuation peak before the financial crisis and the last period of general market bullishness, suggests that valuations in both Japan and Asia are lower than those in 2007 and therefore still have scope to rise. However, the PEs for the US and Europe are higher than their 2007 peaks and appear to have little scope to increase further without moving into clearly over-valued levels. Thus earnings growth is now required if further sustainable gains in these stock markets are to be delivered.

Not enough beef

Over the long term, equity markets rise with the growth of the economy and in particular with corporate profits. Earnings growth is the “beef” that markets require to move sustainably higher. Of the global equity market regions, the US has experienced the strongest economic growth over this period, corporate profit margins are at their highest ever levels and companies have been very aggressive in their use of share buybacks. Yet, even with all these positive factors, forecast earnings have only risen by 11.4% over the 30 month period.

The weakness of the European economies is highlighted by the decline in forward earnings in both the UK and Europe. Some of this can be attributed to recent currency strength, but most of the weakness reflects the lack of demand in the European economy in particular. Japanese forward earnings fell through 2012, have risen sharply since 2013 as “Abenomics” was introduced, but are up only a little over the whole period. Japanese forward earnings are however rising at the fastest rate of all the regions.

We have the most confidence in the immediate earnings prospects for Japan and the UK, which is where we expect to find the beef. In Japan, the weakness of the Yen and the increasing likelihood of wage gains helping to increase consumer spending should continue to improve the corporate earnings outlook. In the UK, the domestic economic recovery is expected to boost the earnings of small and mid-sized companies. Meanwhile, large companies are very sensitive to the exchange rate and their earnings should see a significant boost if the recent spate of currency strength reverses.



Though we expect equity markets to deliver better returns than bond markets this year, we anticipate greater volatility than seen during the last two years.In the longer term, we remain convinced that Asian economies will deliver the greatest growth of all the regions and that this will feed through in EPS growth for Asian companies.   Our model portfolios remain underweight equities in the US and Europe-ex-UK and overweight in Asia, Japan and the UK.

A Stagnant Europe

The outlook for returns from European shares for the next few years is not exciting, though the level of dividend yields is likely to support current prices, thereby limiting the downside risk in these markets.   The investment implications are to remain VERY LIGHT in European equities, where domestic growth is expected to be disappointing and exports outside of the Eurozone are likely to remain under pressure from a strong Euro.

As in the US market, the earnings growth in the Eurozone for 2014 (that is already expected by analysts) is strong, despite the lack of revenue growth expected from most companies. Further, again as in the US, the valuations on these optimistic earnings forecasts are at the high end of the normal range. Core European bond yields are likely to remain low but risks certainly remain in peripheral bond markets.   Political developments need to be monitored closely for any indications that the rise of the anti-EU factions in the peripheral countries begins to change the current support within them to stay in the Euro.

The EU parliamentary elections – According to the opinion polls, the anti-EU, UK Independence Party (UKIP) could emerge with the most votes in the UK’s forthcoming elections to the European Parliament. This apparent rise in nationalist sentiment is not just a UK phenomenon, with the French National Front, Italy’s Forza Italia, Greece’s Golden Dawn, and the Freedom parties in Holland and Austria all scoring highly in opinion polls. Though these disparate parties do not all get on with each other, it is possible that they could, between them, win about 20% of the seats in the new Parliament. This is not likely to be enough to change the path towards greater integration within Europe, but is enough to be a very vocal nuisance within European politics.

Austerity – The peripheral economies (generally understood to be Spain, Portugal, Greece, Cyprus and Italy) have undergone harsh austerity in recent years, leading to very high levels of unemployment (and youth unemployment in particular), in the cause of remaining in the Euro and receiving support from EU bailouts and the ECB. It is perhaps surprising that anti-EU sentiment is not even greater in these countries, but there appears to be a grudging acceptance that the German-prescribed policies of economic orthodoxy must be adopted. These are (i) lower government spending and (ii) smaller budget deficits together with (iii) lower wage levels to regain competitiveness. The stark alternative for these economies is to come out of the Euro and allow currency depreciation to ease their problems, by creating inflation and reducing living standards. Even France, led by a Socialist president, has now succumbed to German orthodoxy on its budget, acknowledging that its levels of taxation and budget deficit cannot be allowed to go any higher, and that spending cuts are necessary.

There are however, two problems with extending the German approach to economic policy to the whole of the Eurozone. First, most of the Eurozone’s exports are to other Eurozone countries, so reducing domestic demand through austerity in one part of the Eurozone merely reduces export demand for the rest of the Eurozone. Second, the peripheral countries’ greatest need is to regain competitiveness against Germany. This would be much easier to achieve if Germany were prepared to become a little less competitive, by having some price and wage inflation. A few years of German inflation at 4% with 0% inflation in the periphery would ease the Eurozone’s problems considerably. However, if German inflation remains at 2%, then inflation at –2% might be required in the periphery; economically such deflation is particularly harmful, keeping unemployment and budget deficits high.   There are few signs that Germany would be prepared to tolerate a 4% inflation rate.

Following the Japanese – The Eurozone is currently edging towards deflation, with the current inflation rate at 0.8%. With its other issues of ageing populations, high levels of government debt and high welfare spending, it shares many similarities with the Japanese economy of a decade ago. There, the economy has, until very recently, been mired in a long period of economic stagnation in which the nominal size of the economy has not changed – there has been some real growth, but this has been offset by falling prices and wages.

Stagnation – Our concern is very much that the Eurozone, following orthodox German policies, with an absence of stimulus from fiscal policy or from monetary policy and with an ECB extremely reluctant to implement QE, may have entered a period of structural economic stagnation, with high levels of unemployment, similar to the experience of Japan. This would be negative for economic activity and indeed for social cohesion in the weaker economies, and, in time, the support for the anti-EU parties may be strong enough to lead to more radical change than the forthcoming elections are likely to create. This might mean a change to policies that were incompatible with continued membership of the Euro.

Just as the UK’s exit from the Exchange Rate Mechanism in 1992 and sharp fall in Sterling marked the start of a new period of growth in the economy and a new bull market in stocks, any country that did exit the Euro would be likely to derive the same benefits. However, for now, continued adherence to the orthodoxy of German economic policy ideas is expected to lead to a period of economic stagnation for the Eurozone economy.