Future Outcome for the Eurozone

I recently read an excellent article on the Eurozone from John Greenwood, Chief Economist of Invesco Ltd. In it he argues that there are now only two possible outcomes to resolve the debt crisis – unilateral default and exit by Greece and possibly other economies or full fiscal union. Prolonged austerity will not work.
 
The first scenario with a Greek exit runs the risk of contagion. A default on all external debts and a new depreciated drachma would rapidly restore Greece’s competitiveness and growth. This would then become an attractive option for Portugal, Ireland, Spain and Italy. Exit would lead to a run on the banks as depositors including foreign institutional lenders seek to protection funds from conversion to new drachmas, escudos, punts, pesetas or lire. Greenwood also detailed the difficulties in constructing sufficient firewalls and concluded there would be grave consequences for financial markets.
 
Full fiscal union means a move to central control of Eurozone government revenues and expenditures with a federal government issuing bonds on behalf on all states collectively. Greenwood sets out some examples from history. The one I found most interesting was the monetary union of the United States. The US created a fiscal union before a monetary union, following the War of Independence where the federal government would bail out the indebted states and pay off foreign creditors in exchange for powers to raise revenue in future. Greenwood argues if Brussels took over the debts of Greece etc. the immediate credit crisis would recede and Euro credit could rank alongside US Treasuries.
 
In the 1830s, following a slump in the rail road boom,  many US states became over indebted again. However the federal goverment which had established a good name in the credit markets did not bail them out to avoid undermining this. Monetary issues were not finally settled until after the Civil War.
 
Various commentators have argued Euro monetary union was destined to fail as it was flawed from the outset. Greenwood concurs that it is a huge mistake to combine economies with different per capita income, productivity and social systems into a single currency. Booms and busts in the periphery will inevitably lead to debt and banking crises undermining the integrity of monetary union. The Eurozone will need to move to a fiscal union with the powers to tax, borrow and spend in the name of the union. If the federal entity is financially secure it can impose a no bail out policy. There would be no repeat of the Eurozone capitulation to bail outs to date that now threatens the monetary union. Greenwood finishes that we’ll know in a few weeks whether we will see break up or full fiscal union.

Prospects for the US Economy

We are all aware of the importance of the US economy, still the world’s largest albeit with China catching up quickly. The rally in equities in the first quarter of 2012 was in large part been due to clear signs of recovery in the US – corporate earnings are good and cash balances high (some of this is being returned to investors in the form of dividends and share buy backs), unemployment is falling, there are positives in the automotive and service sectors and there is stabilisation and recovery in the housing market. Consumer confidence has risen whilst government policy too has been supportive of growth with less emphasis on austerity than in Europe. In addition US banks are better capitalised and have less toxic assets than their European equivalents. At the same time large scale liquidity injections by the ECB in December and February also reduced risk in Europe and buoyed global equity markets including the US.

Despite the encouraging signs there are however economic headwinds and political factors that the US faces going forward. In an election year with a potential change of government there is uncertainty on two issues – taxation and healthcare reforms. Businesses and individuals will be wary about unknowns costs and this could put a brake on economic growth and investment until there is clarity.

Tensions in the Middle East and a sharp rise in oil prices would also impact negatively. However Mike Turner, Head of Global Strategy and Asset Allocation at Aberdeen Asset Management reckons the price of oil would have to reach $150 per barrel before there was a major effect on economic growth.

Another issue is the debt ceiling crisis in 2011 which prompted Standard & Poors to downgrade the US credit rating from AAA. It is feared it may re-emerge in 2013. However Cormac Weldon head of US equities at Threadneedle Asset Management says that the US has not yet engaged in severe austerity and it is set to start next year. If taxes increases and government spending is reduced it will impact on certain sectors such as healthcare and infrastructure.

So what does this all mean for investors? In two words uncertainty and volatility, especially in the short term, through 2012 and into 2013. That said many commentators are cautiously optimistic on the US and the impact it will have on the global economy. The US does have a highly flexible and productive labour market and a strong corporate culture and this bodes well for the medium to long term.

High Yield – The Search for Income

In an economy of balance sheet deleveraging and low growth a key challenge for investors is the search for income. The impact of the financial crisis in 2008 has led to structural changes in the UK economy with very low interest rates having become the norm. By low interest rates we need to distinguish between those that apply to cash and those that affect UK government bonds i.e. gilts. Often the two are confused. For example Coalition politicians defending the austerity cuts often argue that we have to maintain this economic policy and protect our AAA credit rating in order to ensure mortgage rates remain low. I think there is a bit of spin here. The point is that the UK’s economic credibility impacts on gilt yields and hence the government’s future borrowing costs not mortgage rates. The latter are determined primarily by the Bank of England base rate not gilt yields.

The scenario of low interest rates is unlikely to change in the near future as they are required to stimulate economic growth and reduce unemployment. In this sense central banks have shifted from their traditional remit of inflation targeting. Evidence of this is in the UK where inflation has been well above its 2% CPI* target for a long time yet the Bank of England has kept its base rate at 0.5% p.a. for over three years now. Ordinarily interest rate rises are used to reduce inflation but this monetary policy has been kept under firmly under wraps.

In the current environment low interest rates on cash means this asset class is a very poor investment for income seekers and capital is eroded in real terms by inflation. For those coming up to retirement and buying lifetime incomes from pensions there is a double whammy, low interest rates on gilts, supported by QE** has hammered annuity rates which are priced off of gilts. For those lucky enough to have secured retirement income from generous index linked final salary schemes or who bought annuities in the past when rates were higher you may be in a better financial position than new retirees but you will have seen your annual pension increases trailing inflation busting price rises in food, utilities and petrol in recent years. The “grey” inflation rate focused on life’s essentials not i-pads, flat screen TVs and 3G phones is typically higher than average.

So where do investors find income? In a recent article from M&G they highlighted the importance of high yield corporate bonds. Yields vary but may be as high as 8%-11% from relatively good companies. High yield, as it says on the tin offer real rates of return over and above inflation. M&G also point out high yield bonds have outperformed equities since December 1997 and with low volatility. I must stress the comparison was with equity indices such as the FTSE All Share and the S&P 500 rather than actively managed equity portfolios.

Another attractive feature of high yield corporate bonds is that they are much less interest rate sensitive than gilts or investment grade bonds. An interest rate shock, for example a reversal of the BoE monetary policy could send gilts into a tail spin with capital values falling sharply. The return from high yield is more determined by credit risk of the issuing company rather than interest rates. Finally high yield corporates bonds as with other forms of fixed interest are especially tax efficient when held within an ISA. This is because the plan manager can reclaim the 20% tax in interest. In contrast the 10% tax credit on dividends from equities is not reclaimable.

The choice of fund manager is crucial when it comes to selecting a bond fund. Aside from being a firm believer in active fund management rather than passive index tracking M&G made an interesting point. They compared spread dispersions for different categories of credit ratings in June 2007, before the financial crisis and at the end of 2011 and found they had become much greater. To explain. A spread is the excess return of a corporate bond over and above an equivalent gilt. For example if a gilt yields 2% and a corporate 6% the spread is 4% p.a. It is the extra yield the market demands for the additional risk of buying company credit as opposed to a “risk free” gilt. Further most corporate bonds have their credit ratings assessed and typically these are AAA, AA, A and BBB for investment grade and BB, B, CCC, CC etc. for non investment grade. Typically the lower down the credit scale you go the higher the yield. However within each credit category e.g. BB- or CCC+ the spreads vary much more now than they did in June 2007. This means that there are large differentials of value in high yield and a good fund manager is recommended to seek out these stock selection opportunities.

Finally for the sake of balance I must point out high yield bonds are not the same as cash and capital values can fall. They also carry default risk although pooled investments reduce the impact. In addition high income can also be provided from structured products and equities.

* CPI – Consumer Prices Index             ** QE – Quantitative Easing

Medlee of Comments

I am awaiting something inspiring to write about; nothing has fired my imagination in recent weeks. So in the meantime here are some random thoughts on investment issues.
 
Markets have been weighed recently by fears over Spain’s economy, after a poor government bond auction and rising bond yields. Spanish stocks also fell on Thursday whilst other markets rallied. Spain has a weak economy, very high unemployment levels and an overhang of a collapsed property boom – unsold homes, falling prices, negative equity, repossessions, failed developers and bad debts sitting on bank balance sheets. Whether Spain needs to be bailed out or could be remains to be seen. It is a much bigger economy than Greece and whether the IMF* can provide a firewall to protect the global economy from contagion is unknown. I conclude recent events will be a pattern for the next year at least, periods of calm and relief rallies, followed by emerging nervousness, crisis and volatility. Sovereign indebtedness is a deep structural problem which will take years to fix.
 
 
A new tax year signals a new ISA allowance of £11,280 of which a maximum of £5,640 can be allocated to cash. For those wishing to use stocks and shares ISA allowances but nervous of market volatility, can I remind you of Fidelity’s phased investment facility in which money can be fed into the market over six months, the option of monthly ISA contributions of up to £940 p.m. or the use of Fidelity’s ISA Cash Park, a temporary facility which permits a rapid tactical switch to equities if markets fall sharply.
 
 
For those of you receiving income payments from Fidelity I have been advised by one of my clients, that distribution statements are no longer sent out automatically now but have to be individually requested.
 
 
Finally a thought on income investing. With yields on UK gilts and other government bonds at record low levels, southern Europe excepted, and interest rates on cash very low, the search for income is a major investment theme. Selected high yield corporate bonds offer high income or equity like total returns but with lower volatility than their own equity. In addition dividend investment is back in vogue with increasing interest in global income. Traditionally UK investors were largely confined to domestic equity income but now a new IMA** sector the Global Income has been launched to accomodate the increasing number of fund offerings and reflect this distinct asset class. The pool of investible companies for dividend income is much bigger outside the UK whilst large cash balances are being returned to shareholders in the form of dividends or share buy backs. This reflects the growing focus on shareholder value not always evident outside the UK.
 
For lower risk growth investors dividend re-investment is an excellent strategy for long term returns. You will no doubt have seen the data that shows historically a significant amount of return from equities comes from dividend re-investment.
 
* IMF – International Monetary Fund
 
** IMA – Investment Management Association.
 
Mike Grant

Expectation of Future Investment Returns

In the same week I have seen polar opposite opinions on expectations for future returns from equities. According to Citigroup the FTSE 100 index will double in value in the next 10 years. That takes some faith given the index is still trading at around 1,000 below its December 1999 peak of 6,930. The drivers will be earnings growth, strong balance sheets, high cash balances, mergers and acquisitions and a focus on shareholder benefits. This argument has some legs; it is clear the corporate sector is in rude financial health and sits on a large cash mountain.

Against this conclusion is the house view of Newton fund managers, part of BNY Mellon who wrote an excellent and thoughtful analysis on expected investment returns from developed economies. Their thesis is that since the banking and credit crisis in 2008 it is clear we are in a very different world to that which prevailed in the previous 30 years. Here they cited the great bull market from the early 1980s to the early 2000s driven by falling global inflation, lower bond yields (these lower discount rates on future cashflows and hence supported higher prices for financial assets), loose monetary policy, globalisation, deregulation and financial innovation. It was also a period of relatively muted volatility compared to the 1960s and 1970s. According to Newton* we had super normal total returns of 17.2% p.a. from UK equities over a 20 year period from 3/12/80 to 31/12/00.

Newton argue we are now in a radically different world with an extended period of deleveraging (debt repayment) which will not progress smoothly. Western authorities are in a trap, unable to save or grow their way out of debt and will focus on treating its symptoms rather than the root causes. They are struggling to maintain bubble era levels of activity and asset prices to support unprecedented levels of debt. In this environment debt will be a significant drag on economic growth.

Newton also argue “risk free” interest rates on government bonds are artificially low and their risk is mispriced. The banks have changed from being agents in the economy to being principals, they are too leveraged, still too big to fail and carry systemic risk. The global financial system is comprised of a web of carry trades** whilst financial innovations such complex derivatives, high frequency trading, hedge funds and structured products (with their attendant counterparty risk) which account for much day to day market trading has created heightened volatility.

This analysis predicts low investment returns and high volatility in an environment of structural rather than cyclical over indebtedness and unsustainable sovereign finances.

The shift of realities is a game changer when it comes to investment returns. During the great bull run, risk was being out of the market, not owning financial assets such as equities, bonds and property. This was the era that passive or index investing was born and thrived with many active fund managers struggling to outperform trend returns which were on a upward trajectory. In the new paradigm capital protection, losing less in the more frequent periods of asset falls may be more profitable than chasing returns. A focus on not losing money means absolute return strategies are required whilst index based returns and benchmarking to “risk free” government bonds will be unfavoured.

Active flexible asset allocation and management will be required, traditional asset correlations may prove unstable, certain hedging strategies may fall foul of regulatory authorities and a focus on volatility as the major risk may be dangerous. Two examples were given. Firstly in the late 1990s during the technology boom equity volatility was at low levels but this proved to be a poor measure of risk as the subsequent bursting of the bubble proved. Similarly in March 2009 at the nadir of equity markets, volatility was very high and risk reduction suggested. In reality selling rather than buying equities would have been a poor decision as the subsequent rally proved.

Newton also emphasised the prime importance to total returns of the compounding of re-invested income. Robust and sustainable income streams are likely to matter more and prove less volatile. Unconstrained forms of investing should also be favoured.

In conclusion Newton said if they are correct then we are in the early stages of a major transition in attitudes; if wrong we are in the foothills of another structural bull market. Time will tell who is right Newton or Citigroup. Newton’s analysis feels right to me but their thesis is focused on developed economies of the West. As emerging markets continue their inexorable economic growth decoupling can be expected and this may drive a global bull market. You will be aware for example that significant earnings from FTSE 100 companies arise from emerging markets. Consequently Newton’s view may be too cautious.

What is clear to me that there is evidence of Newton’s thesis playing out in the last decade, with indices moving sideways, high volatility and active fund management being favoured. Interesting times lie ahead.

* Source: Thomson Reuters Datastream; total return of FTSE All Share Index.

** Carry trades are strategies where investors borrow money at a low interest rate to invest in an asset that is likely to provide a higher return. It includes currency investments.

Mike Grant

 

When is a default not a default?

When it is a Greek debt restructuring deal! This is the largest bond swap in history with the majority of private investors such as banks and pension “voluntarily” accepting up to 74% haircuts worth around £90 billion in total. This slashes the Greek debt burden and triggers a further £110 billion in loans from the so called Troika (IMF, EU and ECB). The question is is this a default? The D word is feared by the markets, central bankers and politicians alike due to upstream losses and fears of contagion.
 
The answer lies with the controversial “Collective Action Clauses,” that the Greek government can impose on the miscreant bondholders who do not want to accept the write downs. Ratings agencies say if these are invoked Greece will be in default. Further ISDA, the International Swaps and Derivatives Association is due to decide if the credit event will trigger Credit Default Swap (CDS) payouts? You will recall these are insurances taken out by bondholders to cover default risk. By definition a claim on CDSs means default and losses for the CDS issuers and could trigger further sell offs in the bond markets although some argue these events are already priced into markets.
 
If successful this deal could be a key step in stabilising the EuroZone and the financial crisis in government debt together with the second tranche of easy money from the ECB. The focus may then shift to the fundamentals of the global economy. My feelings are that the debt crisis is not over yet and interesting times are ahead.
 
This post is not recent and some information is out of date
 

Cash Savings & Comparison Website

With inflation falling, cash now offers better real returns. In addition increasing competition for cash savings is leading to higher interest rates and better terms, for example on accessibility or not employing temporary bonuses. These attract customers with high interest which tumbles to a paltry rate after six months or a year at the end of the bonus period. Deposit takers have historically relied on customer apathy not to move monies. Shockingly many accounts may be offering rates as low as 0.1% gross or 0.5% p.a. gross. Do you know what you are getting on your cash savings?
 
With the market hotting up it is now a good time to review the interest you receive on your cash accounts. I know shifting money can be a hassle but it is worth the time with large deposits. For example if you can secure an extra 1% p.a. gross interest on £50,000 this equates to £500 before income tax. Not to be sniffed at. Further with rates on the best accounts paying around 3% p.a. if you are receiving 0.5% p.a. currently the reward for the effort of switching is a no brainer.
 
A further incentive to consider savings now, applies to those seeking to use Cash ISA allowances for 2011/12. Time is running out before the end of the tax year. To this end I wish to recommend a comparison website I have learned about – www.savingschampion.co.uk . Whilst there are other good sites such as MoneyFacts and Moneysupermarket that I have referred clients to, this one is refreshingly simple with excellent content, high clarity of display and ease of use. The two female founders also have a background working with IFA firms, Anna Bowes as an adviser so I guess that is an added attraction for me.
 
Please note Montgo Consulting Ltd does not verify the accuracy of the content or take responsibility for third party websites

Equity Markets Rally

You will have noticed that equity markets have rallied in recent weeks. This is due in part to the European Central Bank (ECB) firing its “big bazooka” at the end of December, with unprecedented buying of government bonds and injecting liquidity into the financial system. The result has been a very large reduction in sovereign bond yields, notably in Italy and easing of bank funding pressures. At the same time positive economic data from the US including falling unemployment has cheered the markets. However frequent comments have been made that central bank and government fiscal measures to address the EuroZone debt crisis has merely been kicking the can down the road, meaning the symptoms, such as liquidity and access to credit are being treated not the underlying causes. There is simply too much government debtedness which will not go away overnight.

The UK has just been placed on negative watch by Moody’s with a risk that its coveted AAA credit rating faces a potential downgrade in the next 18 months. However the UK is in a stronger position than many developed economies for various reasons. Firstly much of our debt, in the form of government bonds or gilts is long dated and therefore the UK does not face short term refinancing pressures like other economies. Secondly there is more scope in the UK for the use of “financial repression,” which are processes designed to keep bond yields low. An example of a tool for this is Quantitative Easing (QE). This reduces the cost of government borrowing, making debt repayments easier and also contributes to inflating an economy out of debt. Despite the UK’s safe haven status the key problem with the UK is anaemic economic growth.

To date the crash in global stockmarkets that I feared in the autumn has not materialised. However given the observation above that the underlying causes of the EuroZone debt crisis have yet to be addressed the capacity for a shock remains. Right now I am happy to remain in cash although I am pondering other low risk assets for my pension funds.

 This post is no longer recent and some information is out of date.