Homogenised bulls

Using peer pressure to create a stockmarket rally

Currency-adjusted, Japan is the best-performing major stock market so far this year. This has continued the uptrend that began in late October of last year, a move that started with the announcement of an increase in QE from the Bank of Japan. This is the second phase of the Japanese equity bull market that was kick-started by Abe’s election victory and the introduction of Abenomics in late 2012.

That first phase saw shares rally as the currency fell sharply, government spending was boosted and an aggressive QE policy from the central bank. For the most part it was driven by foreign investors who were quick to understand the reflationary impact of these policies and their impact on corporate earnings. Japanese domestic investors were not major buyers during this phase of the market. Then from May 2013 to November 2014, the market consolidated the very substantial gains made in the prior six months.

Over those eighteen months, a number of key, interlinked, institutional changes were, however, implemented in Japan as part of Abe’s “third arrow” of structural reforms. Two of these have been crucial for the stock market and both rely heavily on the Asian concept of “face” and the strong Japanese desire not to be seen as out of line with the rest of society.

The first change has been to assert control of the Government Pension Insurance Fund (the GPIF). By insisting that it take notice of the Bank of Japan’s new inflation target of 2% and the effects of the QE programme aimed at generating that inflation and by replacing the previous chairman, the government has forced the GPIF to reconsider its strategic asset allocation, which was heavily biased to Japanese Government Bonds with negligible yields, towards much higher weightings of Japanese shares and international securities. As the leading pension fund in the country, the actions of the GPIF are carefully monitored by the other pension and investment funds in Japan and then copied, as is typical in the Japanese culture.

The second change has been the introduction of a new stockmarket index, the JPX Nikkei 400, which the GPIF is using as its benchmark for the domestic Japanese equity mandates that it is awarding as part of its move towards greater equity exposure. Membership of this index is not solely determined by market capitalisation, but also by companies’ success in implementing good standards of corporate governance together with operating profitability and, most crucially, corporate return on equity – which for shareholders is possibly the critical measure of profitability. For companies that would normally expect to be included in any list of the top 400 Japanese companies, the discovery that they do not qualify for this index has become a mark of shame.

After decades of keeping shareholder interests a long way down the pecking order of corporate priorities, the introduction of this index, and its use by the leading investor in the country, has finally produced a change in corporate mindset. For example, Amada, a leading Japanese toolmaker, was mortified to find itself excluded from the index last summer. It has recently announced that for the next two years it will pay out half of its net profits as dividends, use the other half to buy back shares and hire two independent non-executive directors by the middle of next year.

The result of these changes is a dramatic re-allocation towards equities by Japanese institutional investors – this is most likely to be seen in the new financial year which has just begun (April 1). For the first time in a generation Japanese investors are likely to become significant net buyers of Japanese shares. Simultaneously, Japanese companies finally have a good reason to be far more shareholder friendly, to make profits, to declare them as such and to reward their shareholders with dividends from those profits. This is the path trodden by many US companies over the last five years and has been very rewarding for shareholders there. It may finally be time for shareholders in Japan to enjoy the same experience.

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.


Economic outlook

Five years on from interest rates being cut to almost zero in most Western economies, and the introduction of QE programmes in the US, UK and Japan, the global economy finally seems to be moving onto a more secure footing.  Risks remain though, particularly the high levels of government and consumer debt in most Western economies, which remain a constraint on future growth.  In addition, the weakness in inflation indices and continued high levels of unemployment, mean that a renewed global economic downturn, in the immediate future would be very damaging, as there would be very little policy flexibility to offset economic weakness.  Our regional views are as follows:

  • The UK economy has been recovering strongly since last spring when the Help to Buy scheme was announced.  This recovery has been led by housing and mortgage demand, rather than by the business investment that is required for a healthy and sustainable economic recovery.  However, the consumer can drive a continued recovery through 2014 and up to the 2015 election, if savings rates continue to fall.
  • The US economy has entered 2014 growing at a near 3% pace, and this is expected to continue for 2014.  As in the UK, business investment is still a problem, as companies appear far more concerned with growing dividends and buying back shares to boost their share prices than by investing for future growth.
  • The European economy is still struggling. Growth should be positive in 2014 after close to zero in 2013, but recovery will be constrained by continued austerity by most governments, negative inflation rates in many peripheral economies, and by banks still seeking to reduce their loan books ahead of the ECB’s Asset Quality Review later in 2014.
  • The Japanese economy continues to respond to Abenomics.  The increase in the National Sales Tax from 5% to 8%, which will take place in April, will mean a strong first quarter but a weak second quarter.  However, the Bank of Japan has indicated that it is ready to increase its already large QE programme to mitigate any economic weakness.
  • In Asia, Chinese growth is slowing as the  authorities there are seeking a rebalancing of growth away from the wasteful over-investment seen in recent years towards greater consumer spending.  Higher wages have been a key part of this, but this has been funnelled into property speculation rather than consumption.  The central bank is trying to deflate the housing market without deterring the consumer from spending.
  • Other emerging economies are facing problems as the improvements in growth elsewhere are impacting the flows of financial market liquidity, which have been supporting them.  Current account deficits in Brazil, Turkey and South Africa, are now causing falls in their currencies and higher interest rates in response, which will lead to weaker growth in 2014.

2014 should see the world economy move back towards a more normal pace of growth.  For central banks, the dilemma is when to move back to more normal settings for monetary policy.  We believe that official interest rates are unlikely to rise in the West during 2014, as it is likely that central banks will err on the side of risking creating inflation rather than risking creating more unemployment.

Markets outlook

Entering 2014, the consensus amongst most investors on the prospects for the global economy and for stock markets in 2014 is one of greater optimism than for several years.    However the two factors of improved economic prospects and stronger financial markets, do not necessarily occur simultaneously.  Indeed, stronger economic growth has already led to the Fed tapering its QE programme, and investors bringing forward their expectations of when interest rates will begin to rise.  Typically, the financial markets perform well in expectation of improved growth, but when that growth appears, the liquidity in the financial markets is then needed by the real economy for investment.  This tends to mean rising bond yields and falling P/E ratios, and subdued investment returns.

For the UK markets in particular, the domestic pension funds have experienced a significant improvement in their funding position from the combination of rising equity prices and rising bond yields. Many schemes are being advised by their actuaries to take advantage of this improvement and to “de-risk” their portfolios by reducing equities and buying index-linked bonds.

Within bond markets, we are not particularly hopeful of much in the way of returns in 2014, and hold UK index-linked bonds for their favourable tax treatment, and the option they provide should UK inflation expectations increase.  Emerging market government bonds issued in US dollars now offer attractive yields for the level of credit risk that they bring (such as those witnessed in the recent poor economic developments in Turkey and Argentina).

We favour UK commercial property, where we believe that the market cycled has reversed from falling rents and capital values to one where rents and capital values are rising.  The yields on commercial property are also attractive compared with those available on bonds and equities.

Within equity markets, we favour: (i) Japan, but with the yen exposure hedged, as the Bank of Japan will continue to print money until economic recovery and inflation appear well-set; (ii) UK smaller companies, which for many years have not delivered the extra performance over large and medium-sized companies normally achieved from such investments – the current strength we are witnessing in the UK domestic economy should be reflected in better performance from smaller companies;  and (iii) Asia, where valuations are historically below average in absolute terms and long term growth prospects remain strong.  We have a neutral view on the larger companies in the UK equity market, with valuations on the FTSE100 Index near their long term averages.  The market would benefit from weakness in the pound, as profits in the second half of 2013 have been hurt by the strength of Sterling against the Dollar, Euro and Yen.  We expect the Dollar to be the strongest currency in 2014, but would expect a stronger Pound against the  Euro and Yen.

We are more cautious on the US and European equity markets.  In the US, corporate earnings expectations are already very high, and the valuations on those expectations are also at historically high levels, so strong performance from US equities will be difficult to achieve.  In Europe, in addition to high expectations of earnings growth and above-average valuations, as in the US, the growth outlook also remains subdued, bringing an extra degree of risk to European share prices.

We expect equities to outperform bonds during 2014, as they did in 2013 but expect the year to be both less profitable and more volatile for investors.


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.

A believer in the Abe lever – Japanese shares

The end of bear markets are periods when investors are delighted that they do not own a certain type of asset.  This usually means that the performance has been very poor for a long period of time, and for reasons that most investors believe will persist.  Typically, on long term valuation criteria the assets are understood to be cheap, but no one can envisage a situation whereby the valuations should rise.

Bull markets begin at the end of bear markets and tend to occur in three waves – the first wave, which we have just witnessed in Japan, occurs amid disbelief and surprise.  The second wave occurs as investors shift from disbelief to belief and it appears quite rational to buy as the fundamental news improves, and the third and final wave is the bubble wave as investors shift from belief to high conviction that prices must continue to rise, because the fundamental story is so compelling.  Between each wave is some sort of correction, which can encompass sharp falls in share prices.

Japanese shares were in a bear market for 23 years from 1989 to 2012 – there are probably few investors around today who can remember the last time Japanese stocks were in a bull market.  The major indices had fallen by 75% over that period, and by last year the equity weightings of domestic Japanese financial institutions were minimal and their portfolios dominated by government bonds with near zero yields.  In addition, many international investors were extremely comfortable with low or zero weightings to Japanese equities in their portfolios. Economic growth has been zero in nominal terms (that is including inflation) for over 20 years, and the legendary Japanese trade surplus of former decades has now become a trade deficit, following the Fukushima accident, the shutting down of all of its nuclear power plants and the consequent need to import a far greater amount of its energy requirements.  It boasted the largest government debt to GDP ratio in the developed world.  Investors who did own Japanese shares, made sure that they did not own very many, as it was so difficult to justify such positions to clients or managers.

By last autumn, over 70% of companies listed in Tokyo traded below book value, and the dividend yield of 2.5% was 3 times the yield available on a 10 year Japanese government bond, even though the dividends paid by companies in the stock market had doubled over the previous decade.  Japanese shares were very cheap but investors would not buy them, because very few believed that the Japanese economy would get back onto a path of growth.  Japan fulfilled all the conditions for an end to its long bear market.

Then, last December, Mr Abe, one of the many former prime ministers of the last decade who had proved ineffective and short-lived, and who regained the leadership of the LDP, fought a general election campaign asking for a mandate for dramatic change to set Japan’s economy on a course for growth.  His plan consisted of three pillars: (i) a short term fiscal stimulus of government investment spending, to boost demand in the short term; (ii) a shift in monetary policy aimed at boosting inflation expectations that would boost demand in the economy in the medium term; and (iii) a package of structural reforms to increase the economy’s long term potential growth rate.  This policy mix was eerily similar to that adopted by Japan in the mid-1930s, which successfully brought their economy out of the problems caused by the Great Depression.

His political timing was excellent in that: (i) the Governorship of the Bank of Japan was an appointment that needed to be made in the first quarter of 2013, and in many people’s eyes it had been the Bank of Japan’s conservative approach to monetary policy management that had been holding back the economy; and (ii) the Upper House elections were due to be held in July 2013, giving him the rather rare opportunity to gain a majority in both Houses of the Japanese Parliament at the same time, and thus be in a position not to have to compromise with opposition politicians.

In a matter of weeks, the consensus view of the prospects for Japanese markets had reversed. Rather than a stagnant economy with no change to policy, there was to be a dramatic shift to a pro-growth and most crucially to a pro-inflation stance.  At the heart of the policy shift was a change in the Bank of Japan’s inflation target from 1% to 2% and a belief and determination from inside the Bank of Japan that this could be attained.  This required a Governor who believed that creating higher inflation was possible, which the outgoing Governor did not; the change from Mr. Shirakawa to Mr. Kuroda brought this in one fell swoop.  To achieve this, Kuroda immediately announced a programme to print 6 trillion yen a month for two years, and so double Japan’s monetary base.  The aim of this programme was and is to raise inflation expectations, and encourage consumers and businesses to spend now, to hold down interest rates, and so reduce real yields in the economy, and most importantly to weaken the yen.

The weaker yen is an enormous boon for Japanese profits, whose companies sell so much around the world.  The profits of the large Japanese companies are very sensitive to the value of the yen, rising strongly as the yen declines.

Over the early months of 2013 the market suddenly found itself with increasing earnings forecasts, low valuations, enormous supplies of liquidity, and with most investors holding very little exposure to Japanese equities, but who believed that they needed far greater exposure.  The market rose rapidly, gaining almost 80% in the seven months from October 2012, to 1276 on the Topix index; this was partially offset for many international investors, who neglected to hedge their currency risk, by a fall of 25% in the value of the yen.  In the three weeks following the market peak on 22 May 2013, it has fallen back by almost 20%, though this still leaves it at the levels it was trading at in early April and 50% higher than the lows from last year.

There are those who believe that Japan has entered a bubble, but bubbles occur at the end of long bull markets, not after just seven months when many investors have had little opportunity to build positions.  The critical insight is that the market psychology on Japan has changed, from being uninvested and comfortable with that position, to being lightly invested but very uncomfortable with that position.  Apart from very short term orientated investors, who have profits to bank, and so will do so, most investors will now concern themselves with being underinvested in Japan, and so any positive news on Japanese growth, Japanese corporate earnings, easy monetary policy and a weaker currency will be seen as good news, and lead them to increase their weightings to Japan.

This summer is likely to see a continuation of the recent correction, as shorter-term investors take their profits and search the world for their next opportunity, and are replaced by longer term investors who need to build up their positions in Japan.   Thereafter, either the Japanese economy will begin to grow faster and inflation pick up a little, which will justify higher share prices, or if growth and inflation are not picking up, then the Bank of Japan will be forced into even greater money creation, and an even weaker yen which would also boost share prices.   In either event, a second wave of the bull market should be expected to begin later this year, though it will be critical to invest in Japanese equities with the currency hedged, since one of the major factors in stronger share prices will be the weaker yen, caused by the aggressive printing of money by the Bank of Japan.

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.

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.


“Zombie” companies: – Why corporate bankruptcies have to increase to spur recovery

Corporate bankruptcy plays a very important role within a competitive, free-market economy. Enterprises that fail were either providing a good or service that was not in sufficient demand from the rest of the economy or were providing a good or service that was not competitive with other providers in the marketplace.  Bankruptcy provides a means for the resources that were being used by the unsuccessful company to be taken from inefficient use to a more efficient use.  If this is continually occurring throughout the economy, then the use or resources will be efficient and the level of economic activity will be greater.

The US economy has generally been very good at this.  As the fortunes of industries wax and wane, both capital and workers can be seen moving from the struggling parts of the economy to the newly growing and profitable parts.  Private sector capital will always be highly mobile, but with relatively poor welfare benefits and the advantages of a common language and laws, the US workforce is also very mobile and ready to change geography and sector of work.

The above is fine in theory.   However, for politicians, elected by voters who want secure jobs, the concept of long term resource efficiency will often play second fiddle to protecting companies from going bankrupt and making their workforce unemployed.  If too many bankruptcies (that should have occurred) are avoided, then there will be adverse economic consequences.

Japan’s long period of very slow growth since 1990 can be at least partially attributed to the reluctance of their banks to foreclose on companies and force them into bankruptcy.  The alternative was to reduce the interest rates due on the loans to very low levels, even though there was little prospect of ever repaying the principal amount – in Japan they are known as “zombie” companies.  This reluctance was for two reasons. Firstly, the banks themselves were critically short of capital, and forcing companies into bankruptcy would mean that they would have to acknowledge losses, which would reduce their capital base and weaken the perception of their capital strength in the market.  Secondly the culture of Japanese society, which like many Asian cultures, places a large emphasis of maintaining “face” and avoiding “shame”.   Going bankrupt and formally not making good on your responsibilities to creditors is seen as very shameful, and many will go to great lengths to avoid it.  In the US by contrast, having a company go bankrupt is seen as part of the learning process to becoming a successful entrepreneur.

Recent data on European bankruptcies by Creditreform Research , is very illuminating.  When ranking European countries by the number of corporate insolvencies per 10,000 businesses in 2011, the four countries with the lowest rates of insolvency are Greece (5), Spain(18), Italy (26) and Portugal (57).  These are the Eurozone peripheral countries with the poorest economic performance.  The countries with the highest rates of insolvency are Austria (152), Denmark (182) and Luxembourg (316), which have all been relatively successful European economies.   The differences in this data between countries strongly supports the idea that an insolvency process that allows bankruptcies to occur easily, works to the benefit if the economy as a whole.

After the 2008 Crash, one of the surprises in the UK economic data in the face of weak economic performance, has been the rate of corporate insolvencies.  In the 1990s, business liquidations averaged about 160 per 10,000 companies, but during and since this crisis the number has not even reached 100.  There is a general sense that, as in Japan in the 1990s, banks are not foreclosing on companies.  This is (i) to avoid even more bad publicity than they have been receiving already, (ii) to avoid selling off whatever assets there are at knock-down prices and so realise larger losses than might be warranted, and (iii) to avoid write-offs from their capital bases at a time when their regulatory capital requirements are rising sharply.  Thus, as in Japan, they are content to roll over existing debt at low interest rates, even though they know that their collateral is worth far less than the loans against it.

The UK therefore probably now has a fair share of “zombie” companies. In the longer term, this will tend to inhibit recovery and growth in the UK economy, but in the shorter term it may well explain why the UK unemployment data has been consistently better than expected.  The other conclusion is that considerable, unrecognised bad debts still exist within the UK and European banking systems.  This underpins our concern that there will not be a return to stronger growth in the UK and Europe for several years ahead, which will limit returns from financial markets.

A layman’s guide to Quantitative Easing

Until very recently, Central Banks generally conducted their monetary policy through changing their key reference interest rate, which was generally the rate at which they would lend to the commercial banks on a short term basis supported by acceptable collateral. Thus the economy was regulated by changing the price of money. Theoretically, by increasing the rate of interest in the economy, the desire to borrow and spend would be reduced and the desire to save would be increased, and economic growth and inflation should fall back. Conversely, reducing interest rates should help to boost economic growth. It is generally accepted by monetary economists that the impact of changing interest rates takes between one and two years to have its full effects on the economy.

However in late 2008, the shock to the global economy from the financial crash that most Central Banks cut interest rates to the lowest practical levels (somewhere between zero and 1%, depending on the system), but still felt that they needed to ease policy further to offset the strong recessionary forces that were being experienced.

Thus, they turned from easing through changing the price of money in the economy to easing through changing the quantity of money in the economy (hence the rather ugly term “Quantitative Easing” (“QE”)). The Federal Reserve and the Bank of England began their QE programmes in April 2009, but in fact the Bank of Japan had been engaging in QE policies since 2003, its rates having reached zero in the previous global downturn.

Until this century, QE had only ever been seen as a theoretical tool in the Central Banker’s arsenal. It was a lesson that some (most notably Ben Bernanke) learned from the Great Depression, where once interest rates reached a low point, the Central Banks felt that there was nothing else they could do. There is thus no history or experience to examine to determine if it works or how it works. The current policy is therefore a live economic experiment.

The manner in which Central Banks have indicated they expect QE to work is as follows. The Central Bank goes into the financial markets and buys securities, typically government bonds, although the Federal Reserve has also bought mortgage-backed securities, and the Bank of Japan has also bought equities and REITs. To finance this they create the money (digitally) and use it to pay the seller of the security (typically a bank). The bank’s assets now consist of more cash and less securities. Typically the income return on the cash will be lower than the income return on the securities they have just sold, and so they have a decision to make. They could choose (i) to maintain the lower income stream, because they might have a great need for liquidity, (ii) to go back into the securities markets and buy some other securities to maintain their income, or (iii) increase their lending to companies or households. Choosing (i) has no impact on the real economy and choosing (iii) clearly has a major impact because it is helping directly to boost demand and spending in the economy.

In practice, what has happened is that banks have chosen (ii), and have sought to maintain their income stream by investing in higher-risk securities. Thus yields have fallen first on government bonds, then on investment-grade corporate bonds and finally on high-yield bonds. This then gives companies the opportunity to borrow at lower rates of interest in the financial markets, which could be used to fund investment. QE, to date, has been a policy that has clearly supported financial markets – it is difficult to see a direct effect on bank lending and economic growth, but it is likely (and claimed by the Central Banks) that economic growth would have been much weaker without QE.

There are some problems with continued applications of QE. Firstly, it is generally believed by economists that QE policies have less impact as they are repeated. Since it is such an unusual policy, the first time it is deployed it has a shock effect, but later iterations do not as the financial system adapts its behaviour to the policy. Secondly, the liquidity of the underlying financial markets may be damaged. For example, the Bank of England now owns more than one-third of all gilts outstanding, and has no current plans to sell them, so the level of liquidity in the gilt market has been reduced by the policy.

The great fear that many commentators have about QE is that by creating more and more money in the financial system without greater economic output, the end result must inevitably be higher prices. In fact higher expected inflation is one of the objectives of the policy, since if people expect higher prices in the future it is rational to buy things now before they rise in price, and so boost demand in the economy today. The response of the Central Bankers would be to say that QE is a reversible policy, and the bonds that they have purchased, can very easily be sold back into the financial markets, so reducing the excess liquidity in the system, and the inflationary threat.

To date, a more realistic concern has been that there is no evidence anywhere in the world where QE has worked. It clearly has not brought Japan out of its long term stagnation, and so far neither the US or UK economies can be said to have recovered strongly. The reason for this is that the extra liquidity generated has remained within the financial system and not found its way into the real economy, and so boosted real demand. If the underlying causes of weak economic growth are that the banking system has overlent relative to its capital, that consumers feel their debt levels are too high, and both feel that they need to retrench (or in the jargon, deleverage their balance sheets), then the current policy of QE will not actually affect the desire to borrow or to lend.

A more radical policy option would be to print money and ensure that it was only used in ways that directly benefitted the consumer’s balance sheet. Thus £450 billion (only a little more than the total QE to date) could be used to give every adult in the country £10,000 to be used either to repay debt, or towards a deposit for the purchase of a first home or into a pension pot. By improving the savings to debt ratio of each adult in the country, the time at which they will once again feel happy to spend more will be brought forward.

Situation Vacant – one new genius economist

There is an old joke that if you laid down all the economists in the world from end to end, you still wouldn’t reach a conclusion. It is certainly a tragedy that as the western world finds itself in the biggest economic mess since the 1930s, the economics profession is unable to articulate clear policies to resolve the problems.

Up until the 1930s, politicians did not see themselves as particularly responsible for the economy. The government’s finances were managed in the same way as any other family unit, in that you made sure that spending did not exceed income, and borrowing was only acceptable to cover the cost of emergencies like wars. Foreign exchange rates were all fixed by adherence to the gold standard and it was considered a shameful act to devalue.

This went wrong in the 1930s when the 1920s financial boom led to a banking crisis the following decade. As the banking system sought to deleverage its balance sheet, asset prices fell and unemployment soared. Wages fell but economic recovery did not come because the economy was in a Depression and companies and individuals did not have the confidence to spend. It took the economic genius, John Maynard Keynes to show how capitalism could get stuck in this Depression mindset with low growth and low interest rates. His solution was that governments should take advantage of their high credit status to borrow the excess savings that were being created by the lack of confidence and go out and spend them to kick-start an economic recovery. He always expected however that once recovery had returned, then governments would seek to run budget surpluses so that the extra borrowing was repaid and hence temporary.

Post-war politicians however focussed on the ideas that (i) budget deficits were now good for the economy and (ii) they had the power to manage the economy to deliver full employment, and ignored the idea of running budget surpluses in the good times to offset the deficits that should be run when bad times hit. As the decades wore on, the politicians promised their people more goodies from public spending, budgets only got balanced in economic boom conditions and the size of the governments’ debts relative to the size of their economies rose steadily.

Recent academic work (Rheinhart & Rogoff) has shown that as the Debt to GDP ratio nears 90%, the capacity for economic growth diminishes markedly. The Western world is at or past these limits and finds itself there just as the next 1930s style banking crisis has hit it. The standard Keynesian response of government borrowing and spending is now either not available since markets are unwilling to lend to some governments because they have lost their strong credit status, or not palatable since it is likely to damage longer term economic growth prospects.

In general the right-of-centre politicians (Merkel, Cameron, Romney) stress the need to get government deficits and debt under control, so as to retain the long term confidence of financial markets. This austerity agenda does nothing for short term economic relief however. The left-of-centre politicians (Hollande, Milliband, Obama) stress the standard, Keynesian policies of spending in the short term to enable recovery to occur. The problem here is that financial markets might only provide the funds at an unacceptably high interest rate, and trigger a wider debt crisis.

The positions of both sides contain important truths, but the arguments display the divisions between economists. Japan, over the last 20 years, can be used as an example to prove each is wrong. The Keynesian response of government borrowing and spending has not led to sustainable economic recovery but has led to a Debt to GDP ratio now of over 200%. However this massive debt burden has also not led to a financial market crisis (yet), as Japanese savers have been happy to lend to their government for miniscule returns.

A Nobel Prize, a place in history and the gratitude of the world surely await the economist who can untangle all this and provide the solution to our current problems.