UK Company Shares – Go Large

During the last 15 years, the UK’s largest companies (constituents of the FTSE 100 index) have delivered significantly lower returns than medium-sized companies (in the FTSE 250 index). We believe that this trend will now reverse over the next few years and the largest companies will outperform the medium-sized companies. We are therefore seeking to move portfolios towards funds with heavier exposure to FTSE 100 companies. 

Our analysis (as described in more detail below) shows that (i) the outperformance of medium-sized companies over this period has arisen from both falling valuations for larger companies, and faster earnings growth, (ii) the disappointing earnings of the larger companies has been due to specific weakness in key sectors, which are heavily weighted in the FTSE 100 index, (iii) these sectors of the market are now attractively valued, and (iv) there are good reasons to believe that these trends will reverse in future years, which (v) has implications for UK equity fund managers. The unusually large outperformance of medium-sized companies has allowed many of the UK’s equity fund managers to deliver extremely strong outperformance of the FTSE All Share Index over this long period. This is because they have a collective tendency to hold underweight positions in the largest companies and overweight positions in medium-sized companies, due to their belief in their stock-picking skills.   Given our analysis, we believe it will therefore be increasingly difficult for most UK equity managers to outperform the FTSE All Share Index.

The outperformance of medium-sized companies over larger companies

During the 15 years to the end of April 2014, the total return from the FTSE 100 index (the 100 largest companies listed and based in the UK) has been a compound annual rate of 3.6%, while the equivalent total return from the FTSE 250 (the 250 medium-sized companies after the FTSE 100) has been 9.9%. This is an astonishingly large differential (6.3% per annum) between different parts of the same stock market over such a long period. About half of this difference in performance has resulted from the change in the valuations between the two indices.  The decline in the forecast Price Earnings Ratio (“PER”) of the FTSE 100 over the period is from about 22.5 times to about 13.5 times while the forecast PER of the FTSE 250 is essentially unchanged (at about 15.5 times).   Over the longer term, valuations of these two indices can be expected to be broadly similar. Though the 40% premium seen in 1999 was exceptional, a move back to a FTSE 100 valuation premium is entirely possible in the next few years, particularly if, as we expect, Sterling declines against the Dollar, since the earnings and dividends of the FTSE 100 are very sensitive to movements in the Sterling-Dollar exchange rate, given the global nature of the very largest companies in the market. The other half of this valuation difference is accounted for by faster growth in expected earnings from FTSE 250 companies than from FTSE 100 companies. These stronger expected earnings occurred in two distinct phases; one from 1999 to 2003 and the second since 2011. The first period reflects disappointment that companies such as Vodafone and BT failed to live up to the wildly overoptimistic expectations that many analysts had during the Tech bubble, while the second period reflects actual earnings weakness due to economic problems following the banking crisis.          

The disappointing earnings of the larger companies in key sectors …

Several key sectors that are more heavily represented in the FTSE 100 than the FTSE 250 have endured particularly large declines in their expected earnings despite the economic recovery.  The prospective EPS of the FTSE 250 have grown by 5% during this period, but the FTSE 100 prospective EPS have fallen by 17%, led by declines in Food Retailing (28%), Oil and Gas (30%) and Mining (54%). Since October 2007, the prospective EPS of Banks have also fallen heavily (by 59%). Together these four sectors, which account for over 40% of the FTSE 100 index, but represent very little of the FTSE 250 index, and their very poor earnings performance, have been significant in curtailing returns from the FTSE 100 index in recent years.

… mean these sectors are now attractively valued …

Following this poor performance, these sectors are now attractively valued compared with the rest of the market – their prospective P/Es are between 10 and 12 compared with about 13.5 for the FTSE 100 

… and the performance trends are now set to reverse

We believe that all four of these key sectors (Banks, Oil and Gas, Mining and Food Retailing) offer attractive potential for future returns, based both on attractive valuations and on fundamental changes that management teams across these sectors are putting into place. They share a common feature in that previous management teams overinvested during the last decade. In Banking, the 2008 crisis showed this to be an error. In Mining and Oil and Gas, the end in 2011 of China’s enormous investment in infrastructure has reduced demand for, and therefore the prices of, commodities. In Food Retailing, the entry of Aldi and Lidl into a saturated UK market has led to a price war that has hit margins and profits. In each of these sectors, new management teams have been brought in, have cut investment and have refocused on cost-cutting and cash generation. History suggests these measures will lead to much more profitable times for shareholders than when managements emphasise growth over returns. Both earnings and valuations are likely to rise. With almost half of the FTSE 100 index undergoing this change, the prospect for future outperformance of the FTSE 250 appears strong.     Investing in markets is most profitable when growth expectations are low and are easily beaten, rather than when growth expectations are high, and thus hard to beat. For the FTSE 250 to meet its earnings forecasts over the next 12 months, earnings growth of about 27% is required, but for the FTSE 100 to meet its earnings forecasts over the next 12 months, earnings growth of about 2% is required. It should therefore be much easier for the FTSE 100 to beat investors’ earnings expectations than for the FTSE 250.

The implications for UK equity fund managers.

In developed world stock markets, numerous studies have shown that fund managers tend to underperform the benchmark index by about the amount of their fees – in other words that the fund management industry as a whole adds very little investment value to their clients’ portfolios. Indeed, since 1990 (to 31 May 2014), the IMA UK All Companies funds index has delivered a compound total return of 7.7% per annum, compared with 8.5% from the FTSE All Share index. However, since 2012 (to 31 May 2014), UK equity fund managers have outperformed their benchmark index – the IMA UK All Companies funds index has delivered a compound total return of 17.5% per annum, compared with 14.8% from the FTSE All Share index – a very strong and highly unusual period of outperformance.  The cause of this outperformance has been the generally heavy underweighting of large FTSE 100 companies by the IMA funds. A reversal in this trend of underperformance of FTSE 100 companies is likely to mean that UK fund managers will revert to their more normal pattern of underperforming the FTSE All Share index. The expectation of better performance from the FTSE 100 index means that, within our Model portfolios, we are seeking to switch UK equity exposures towards funds that have heavier weightings to FTSE 100 companies.

Banking Matters

Healthy banks are a critical ingredient in the economic infrastructure that underpins growth and equity market performance.  Today the healthiest banks are found in Japan and Asia and the weakest in the Eurozone.  Thus banks in Japan and Asia look best placed to support growth in their economies, whilst Eurozone banks appear worst-placed.  This analysis contributes to and supports our current positioning within equity markets, where we favour the Japanese and Asian markets and are cautious on the Eurozone markets.

Five years ago, Hank Paulson, the then US Treasury Secretary, decided that financial markets would be able to deal with the bankruptcy of Lehman Bros, and refused public money to rescue it.  His judgement was that Lehmans was not “Too Big to Fail” and it proved to be wrong, since the following six months led to an almost total shutdown in interbank lending and a collapse in economic activity all over the world.  Governments around the world were forced to provide capital for the weaker banks in their economies and central banks provided the liquidity for banks that the banking system had previously provided by itself.  In hindsight, Lehmans was “Too Big to Fail”, and by implication, so were many more banks all over the world.

Over the five years since then, policymakers have focussed much more on dealing with the macro-economic consequences of the crisis than on dealing with this key weakness that caused the crisis.  Some small steps have been made. Firstly, there is now an official list of systemically important financial institutions produced by the Financial Stability Board, a new global body that monitors the global financial system and makes recommendations for change.  These institutions have slightly higher capital requirements than other banks to reflect the fact that since they are agreed to be systemically important, they will be bailed out in the event of a future crisis.  Secondly, many countries have now brought in the concept of “living wills” for their largest banks, setting out how their activities can be wound down in a rapid and orderly fashion in the event of them falling into a financial crisis.  These steps effectively acknowledge that many banks remain “Too Big to Fail”, and merely attempt to make it easier to deal with any problems that may arise from that reality.

The crisis actually made the larger banks even bigger, since weaker institutions were pushed into mergers with what were thought to be stronger institutions – in the US, Merrill Lynch was absorbed by Bank of America and Bear Stearns was absorbed by J P Morgan, and in the UK, HBOS was forced into a merger with Lloyds.  The financial crisis in Japan over the last 20 years has seen the number of major banks there decline from ten to just three as the banks merged to maintain profitability.  Earlier this year the US Attorney General, Eric Holder, admitted publicly that as well as being “Too Big to Fail”, he believed that the largest banks had become “Too Big to Jail”, since prosecuting these banks for fraud or money-laundering offences might be so damaging to their reputations and their businesses that it might have significant economic consequences.

Within the more troubled Eurozone economies, where governments found it difficult to find buyers for the bonds issued to finance their burgeoning deficits, the local banks were “encouraged” to buy the bond issues, using the extra liquidity supplied by the ECB.  This has created a potential downward spiral, in which a government struggling to service its debts creates problems for its own banking system, which then requires bail-outs from the same government to keep it afloat.  Italy and Spain are most at risk of falling into this spiral.

Almost by definition, banks deemed “Too Big to Fail” have significant political influence, and will use it to fight attempts to make them smaller.  Tougher capital requirements are being imposed, but only to levels that would have been seen as hugely risky by the bank managements of thirty years ago.  Policymakers have a clear conflict here – they are desperate for banks to resume lending to stimulate and support economic growth, but demanding higher capital ratios of the banks only acts to restrain lending.  There has been little in the way of forcing the banks to become smaller entities, apart from the ending of proprietary trading within investment banks and, in the UK, the Lloyds spin-off of a number of its branches under the TSB brand name.

The health of a country’s banking system is generally seen as critical to its ability to support economic growth – though this is less true in America where the corporate bond market is extremely deep and wide, enabling smaller and riskier companies to raise bond finance as well as loan finance.  Some may be surprised that the major economy with the healthiest banking system is Japan – this follows two decades of the banks writing off bad debts and making little in the way of new loans over this period.  Loan-to-deposit ratios are now very low and the capacity to lend to the private sector of the Japanese economy is great, should the demand for those loans improve (which finally appears to be happening).  Asian banks underwent an existential crisis in the late 1990s, and continue to maintain prudent capital and loan-to-deposit ratios – they remain very well-placed to support the expected rapid growth in Asia.  The UK banks are still working their way through a large amount of bad debt related to UK commercial property, but are believed to have made provisions for the bulk, if not all, of their expected losses – they are now in a position to consider lending again, though are still scarred from the experience of the last few years.

It is the Eurozone that is the home of the greatest banking problems today.  Each country has a number of banks that are nationally systemically important, and so do not wish to see fail, but where there are substantial unrecognised bad debts.  These debts cannot be written off without imperilling the capital position of the banks, and so they remain on the banks’ balance sheets. The amount of new capital  that Eurozone banks would be required to find in order to be able to write off these debts and remain in business is believed to be very large, beyond the capacity of the financial markets to provide, and will thus require capital to be provided by governments, which are themselves short of funds.  Until this is resolved, Eurozone banks are in a very weak position to support growth through new lending.

Thus banks in Japan and Asia look best placed to support growth in their economies, whilst Eurozone banks appear worst-placed.  This analysis contributes to and supports our current positioning within equity markets, where we favour the Japanese and Asian markets and are cautious on the Eurozone markets.

The German dilemma

Since the drama of the Italian election in the spring, European politics have been remarkably quiet.  This has been by design – the countries who would like Germany to provide money or ease policy to support their beleaguered economies have understood that it is very important not to scare the German voters ahead of their general election on September 22.  There was a fear that “bailout fatigue” amongst Germany’s electorate might force the politicians to make promises not to provide further support to weaker economies.

In two senses, the result is not in doubt – (i) Mrs Merkel seems sure to remain as Chancellor following the election, as her party is odds on to have the largest share of the votes and (ii) in that event, she will have to lead a coalition to form a government.  What is uncertain is that this coalition will either be a continuation of the current coalition (of Merkel’s centre-right Christian Democrats with the Free Democrats should they reach the 5% threshold of the total vote required to get any seats in the Bundestag), or, if they don’t, there will be a “grand” coalition with the Social Democrats, the large centre-left party.

Whatever the shape of the resulting coalition, the next German government faces a huge dilemma between its two major policy objectives.  It can choose to do all that it can to keep the Euro intact, which will achieve its foreign policy objective of being at the heart of an ever-closer European Union, but at the expense of its economic policy objectives of low and stable inflation and balanced budgets.  Or it can choose to insist that Europe’s economic policies reflect those of Germany and watch as the rest of Europe suffers from economic stagnation until the option of withdrawing from the Euro becomes impossible to resist for some, threatening the survival of the Euro.

To achieve both of Germany’s key policy objectives, the optimal solution is a continuation of the current German stance where they provide the minimum in bail-outs to prevent a default,  in return for a commitment to continued austerity at an agreed pace.  This achieves their dual goals of keeping the Eurozone together, whilst maintaining a German –style attitude to fiscal policy and thus low inflation and a sound currency.  It delivers the “stability” that is so prized by German politicians.  However, this is an inherently risky policy for most of the rest of Europe, delivering a graveyard type of stability.  It will ensure near zero growth, high unemployment and weak banking systems across the Eurozone, for a long time to come.  It is eerily similar to the policy adopted by Japan which led to two decades of stagnation.

To escape this stagnation, countries in the Eurozone have three options: (i) leave the eurozone and repay their euro-denominated debt in their new (and devalued) currency – this would dramatically improve their trade competitiveness and reduce their national debt, but badly damage their relationships with their European neighbours; (ii) persuade the ECB to engage in Quantitative Easing in an effort to create inflation, which would reduce the real value of their debts and might also encourage some growth; or (iii) construct the necessary  banking, fiscal and political unions to go alongside and support the existing monetary union.  At an aggregate level the economy of the Eurozone does not have great budget and trade deficits.  It is only at a national level that the problems appear, which implies that a deep and real economic union between the countries can be successful.

Of these three options, the first is seen as suicidal by incumbent politicians, not only for their prospects for domestic re-election but also for their chances of any future European roles in Brussels.  The second is hard to imagine, since it would require both the ECB and the Germans to support a higher inflation objective.  The third is very complicated to achieve – in 2011 the German Constitutional Court pronounced that the German constitution does not permit further significant political integration without a German referendum.  It would also probably require referenda in several other Eurozone states.  This is though the most logical solution to the Eurozone’s problems.

The banking systems across the Eurozone remain very weak, with the OECD recently estimating that since the crisis began, Eurozone banks have reduced the size of their balance sheets by €2.8tr but have a further €3.0tr still to go, from total balance sheets of approximately €32tr. The banks, particularly in the peripheral countries are in no position to support growth by increasing their lending.  The outlook for economic growth in the Eurozone is thus very restrained, meaning that unemployment will remain very high and that governments will continue to struggle to deliver deficit reductions.

The implications for investors are that Eurozone growth will be very sluggish (even though in the short term growth may be improving), and will remain so as long as Germany’s preferred policy approach continues to hold, since no further fiscal or monetary stimulus will be supplied to the eurozone economy.  We remain very cautious on European equities, which do appear cheap, but that cheapness is concentrated in banking shares and in the markets of the peripheral economies whose prospects remain very challenging.

Cyprus – who next?

The starkest lesson that should be taken from the Cyprus crisis from all in the eurozone is that no bank deposit is guaranteed.  It is always ultimately a loan from the depositor to the bank with the possibility that your government may mitigate any loss.  Depositors with more than €100,000 in local Greek, Portugese, Spanish and Italian banks should now be giving serious consideration to moving their money to stronger banks in safer countries, as also might those with less than €100,000.

Cyprus represents 0.2% of the eurozone economy, so the amount of bailout money required for it to avoid defaulting on its debts was never a major economic problem.  However, it has posed significant political problems, not least because many Northern European nations saw the Cypriot banking system as profiting from black money from Russia and elsewhere, and therefore less deserving of rescue.  The crisis has underlined that, though the euro is the currency of one of the two largest economies in the world, its economic policies are driven by politicians of what are, in global terms, rather small economies, who do not appreciate the wider implications of the decisions that they make.

Until last summer, the euro crisis was spiralling out of control as banks with poor asset bases required government bailouts from governments, which themselves were struggling to raise money to fund their deficits.  The capital that was injected into the banks was then invested in government debt of the home country because (i) it was the patriotic thing to do and (ii) the yields on offer were very attractive.  Thus weak bank finances created weak government finances which further weakened the banks.  At the July EU summit last year, a major breakthrough seemed to have been achieved when it was agreed to try and stop this vicious circle by using the ESM to directly recapitalise weak banks, in a way that this would not be a liability of the national government.  In addition, it was agreed that the eurozone needed a full banking union in order for the monetary union to work.

This analysis was sound.  However, by September Germany was backtracking on this agreement, and now does not support using ESM money to recapitalise banks, insisting that this is a matter for the individual country to sort out.  Further, one of the fundamental elements of a banking union is a Europe-wide deposit guarantee insurance programme, and here again Germany has insisted that this is the responsibility of the individual country.  The political will in Germany to provide money for more bailouts has declined markedly since last summer.  It should also be noted that Cyprus did admit at the height of the crisis, that it did not have the money to honour its deposit guarantee scheme – this is also likely to be true in several other weaker economies.

A crisis in the next few months, ahead of the German elections would bring together the “austerity fatigue” that is evident in many Southern European countries like Greece, Spain and Portugal with the “bailout fatigue” that is evident in Northern European countries like Germany, Finland and the Netherlands.  It could thus be that the tiny Cyprus bailout debacle is the first in a chain of events that leads to the end of the euro.  The withdrawal of deposits from weaker banks in the weaker countries could lead to bank failures which require their governments to recapitalise them with money that has to be borrowed, pushing up their bond yields and creating another sovereign debt crisis.  A similar tough approach from the Northern European countries, to that they adopted with Cyprus, could set the terms of a bailout so high that the debtor countries will not accept them and instead choose to exit the Euro.  It will be the peoples of these countries, rather than the politicians, who make this happen.

The investment conclusion is to remain very wary of most euro-denominated investments until a more sustainable monetary system is in place in Europe.

A layman’s guide to the LIBOR scandal

LIBOR stands for London InterBank Offered Rate. It has become the global benchmark for market interest rates – these are related to but different from the official interest rates set by Central Banks at their policy meetings, eg Bank of England Base Rate.

Each day at 11am, a group of banks (a different group for each of 10 currencies, generally those who are considered most active in each currency) submit to the British Bankers Association (via Reuters) the rate of interest at which they believe they could borrow from other banks over 15 different maturities ranging from 1 day to 1 year. For each currency and maturity, the BBA exclude the top quartile and the bottom quartile and calculate the average of the middle two quartiles. This average is then published as the daily LIBOR fixing. Over time this has become the benchmark used for market interest rates (similar to the FTSE 100 Index used as the market benchmark for UK stocks), and has thus become the reference for nearly all derivative contracts relating to interest rates and many other loan contracts. Estimates as to the total value of contracts outstanding in LIBOR-related contracts vary since much of the trading is carried out as transactions directly between banks and not on market exchanges, but $300 trillion (12 zeroes in a trillion) is probably a conservative estimate – equivalent to more than $40,000 for every human being on the planet. A change of 1 basis point (0.01%) for 1 day on that nominal exposure results in $120 million of cash flow difference moving around the global financial system.

Arguably there are 3 scandals (so far).

  • From 2005 to 2007 when light-touch regulation was in vogue and banks proprietary trading desks were making enormous profits with consequent internal political power, it has become apparent that traders at Barclays and other banks sought to influence the rates that were contributed to the BBA by the rate contributors both at their own bank and in at least one case in other banks too. They were doing this to suit their own trading positions (by trying to get LIBOR to be marginally higher or lower so that they would make greater trading profits)
  • During the 2008 crisis, when lending between banks broke down and the entire financial system came close to collapse, there were no actual trades on which to base the numbers that the banks sent into the BBA. Further many banks did not wish to disclose the weakness of their positions to the wider world and so told their contributors to bias downwards their expectations of what interest rate they would have to pay in the market should they have been able to.
  • In 2007 the New York Federal Reserve were sufficiently concerned by what they felt was a weak process for such an important market price, that they wrote to the Bank of England about their worries. Mervyn King and Paul Tucker appear to have done very little in response to this warning, a fact that has already been picked up by the Treasury Select Committee.

Of these three scandals, the first is criminal if true and can be proved. However the method of calculation is designed to throw out entirely the very high and the very low inputs – it would require an enormous conspiracy between many banks to actually alter a LIBOR rate. The third is a political loss of face for the Bank of England and King and Tucker in particular – it will probably cost Tucker the chance of succeeding King as BoE Governor. The second is almost certainly true but equally contributed to keeping the whole financial system alive – the world was so chaotic at that time and no actual interbank trades were taking place that every LIBOR rate input was a judgement without any evidence to support it. It will be difficult to prove in a Court of Law that a knowingly wrong number was submitted. It is entirely possible that had banks contributed less optimistic judgements of their ability to borrow at the time, then the higher LIBOR rates this would have created could have made the crisis worse

Note that the 2005-2007 scandal involved only dollar and euro interest rates but not sterling rates, so no sterling borrower or lender will have been damaged by it. However this scandal reinforces the long-running narrative of politicians that banks have become forces of evil and must be increasingly heavily regulated. Sackings and resignations of the interest rate traders and many of their superiors right up to CEO level have and will continue to occur. A new system for calculating market interest rates is likely to be brought in in due course, one that will be based on actual transactions rather than best guesses. In the meantime compliance departments will be scrutinising very carefully every input to the BBA.

A three dimensional view of UK financial services – regulation, price and trust

Prior to the Thatcher government’s move to deregulate the industry, UK financial services were characterised by heavy regulation, high prices and confined to a relatively small group of people who were considered specialists. Thus, you could only get a mortgage from an institution that you had been saving with for some time and where you passed an interview with the manager – then you paid the rate of interest that they said. Those wishing to save had two choices; either buy an insurance bond of some description from a salesman where the commissions and investment performance were not visible, or go to a stockbroker who would make investments for you in shares by trading with his friend on the floor of the Stock Exchange called a jobber, and then charge you a fixed, and large, commission. In summary there was a high level of regulation, prices were high but there was also a high degree of trust from the consumers of financial services towards the providers, some of which could be attributed to consumer ignorance, but bank managers and stockbrokers had a high social standing then.

The deregulation of the financial markets began in earnest in the 1980s, most famously with the “Big Bang” of 1986, blowing open the restrictive practices of the UK securities markets and allowing the banks to own and operate securities companies. A boom in house prices and the sale of council houses saw greater demand for mortgages and many more entrants into the mortgage market, which became a low-margin product used to sell a much higher-margin endowment or savings scheme to repay the capital at the end of the term. The unit trust market expanded on the back of this new demand, a bull market was well underway and suddenly everyone wanted product to supply this new demand for long term savings. As the bull market of the 1980s led into the bull market of the 1990s, more and more investment products came out and business models evolved from providing good advice to clients towards delivering sales targets. As the level of regulation declined, competition increased and pricing fell – the performance of the products was good but there was a decline in the level of trust between financial advisers and their clients, as a “product-push” mentality developed.

The post-bubble bear market from 2000 to 2003, saw US interest rates cut to 1% and a new bull market in housing. Financial innovation in securitised and derivative markets dominated by the major banks and a massive increase in financial sector gearing meant that profits from advising clients well became puny compared with the profits that could be generated by the banks from their trading books in these areas. Regulation came to be seen as inimical to innovation and capitalism itself. The bursting of this bubble that has been witnessed over the last 5 years has produced terrible returns for investors and demonstrated that very low levels of regulation, even though combined with relatively low pricing, has come at the cost of a total breakdown in trust between financial institutions and their clients.

What is needed in the next phase of history for the UK financial services sector, is a combination of 1) heavier regulation, particularly over institutions in the investment banking markets and the inherent conflicts of interest they contain; 2) the costs of this regulation  not  falling upon the ultimate purchaser of financial services and 3) new business models that are able to rebuild the trust that needs to exist in the financial services sector between an advisor and his client.

The financial services industry has to get back to a situation where the client is assured that the only interest of his adviser is to give him the best personal, financial advice. To work at its best this means advice needs to be on a fixed fee basis rather than remuneration tied to the purchase of particular products or other services. This may be revolutionary but its time has come.

Paying for the privilege of lending

Investors who wish to buy Swiss government bonds and would like to be repaid within 4 years, now have to accept not a low interest rate, nor even a zero interest rate but a negative interest rate. That is to say the lender pays the borrower real money for the privilege of lending. Similarly in Germany, a 2-year bond was recently issued with a 0% coupon, and on June 1st was trading in the market at above 100 – investors were happy to guarantee a loss if they held the bonds until maturity. Elsewhere government bond yields in the US and the UK are trading at just about their lowest ever levels – lending to governments has never been a less well-rewarded activity and this at a time when governments owe more money than ever before. Greece, has just defaulted, and the media are full of stories of sovereign credit risk. The fundamentals would indicate that this is a very risky time to be lending to governments but most can borrow large amounts very easily and at astonishingly low interest rates.

For Germany and Switzerland the reason for the negative yields is the rising expectation of a potential break-up of the Euro. The Swiss Central Bank has publicly stated that it will print unlimited amounts of Swiss Francs to ensure its currency does not strengthen further against the Euro. However this is not believed by the market due to the long history of conservative Swiss monetary policy. If the Euro were to break up, the demand to convert Euros into Swiss Francs would be enormous, and far greater than the Swiss Central Bank would be prepared to supply. Similarly in the event of a Euro break-up, Germany could be relied upon to have the currency that the world would want to hold. So the negative yields on offer represent the cost of the implicit currency option in the event of a Euro collapse. Germany is the more risky bet here, since it remains the case that one of the few remaining solutions to the crisis, is a much deeper European level of fiscal and political integration in which Germany does assume some liability for the debts of the other nations. If this occurs, Germany’s creditworthiness deteriorates and it may well lose its AAA status.

For the UK and the US, bond yields are positive but are negative in real terms after adjusting for inflation. Yields of around 1.5% over 10 years are below the respective Central Banks’ targets of 2% for the UK and 2.5% for the US. Yields this low are manifestations of demand factors as both the Bank of England and the Federal Reserve have bought large quantities of government bonds with newly printed money. Further the commercial banking systems of both countries have been forced to have much larger holdings of government bonds to bolster their balance sheets. Investor sentiment has been steadily more cautious over the last year, moving away from equity investment and towards more conservative instruments. For most individual investors though, who have to pay tax on the bond coupons, most government bonds  offer negative after-tax yields, even before inflation.

Recent dramatic declines in government bond yields outside the Eurozone periphery, are indicating that the next Euro crisis is close to hand, with attention shifting away from the Greek elections and towards who will recapitalise the bankrupt Spanish banking system. Currently Germany is against every possible solution – it is opposed to (i) common Eurozone bonds, (ii) infrastructure-spending bonds, (iii) bailing out other countries banks, (iv) reducing the drive towards fiscal rectitude, (v) a huge deficit-financed boost to public spending, (vi) the ECB printing money and (vii) any country leaving the Eurozone. Several of these are becoming mutually exclusive, and Germany will have to choose.

Elsewhere in the world, the recent economic news from the US, China, Brazil and India has been disappointing. Growth is slowing and there appears no rush from any policymaker to do anything about it other than to re-iterate their strong desire for growth to occur. Behind the scenes, concern will be growing and some policy action (quite probably co-ordinated) is likely in the next 2 months. This would be good news but may first require a crisis to bring it about. Equity markets are very oversold and cheap if one believes that growth will return again in the near future. Much negative news is priced into financial markets. Longer-term investors can begin to buy some equities at current levels, those with a higher risk aversion may prefer to see the crisis before adding to positions.