PanAsset

Look hard at income and income growth

09/03/2010 00:00:00

World equity markets have been powering ahead. The US recovery looks stronger, which in turn encourages investors in Asia and Europe to increase their exposure to risk assets. The monetary authorities of the world have rattled their sabres about increasing interest rates and withdrawing some of the special liquidity they put into the system, but they have not yet got far in moving to tighter money.It is perhaps time to pause and remember some of the negatives still lurking beneath the easy money. Several countries have now started to increase interest rates. More will do so as the year advances. India, China, the US and the UK are all embarked on some monetary cooling. There are still huge imbalances between the exporting high savings countries and the importing high borrowing countries. We are living through a slow revolving sovereign debt crisis, attention moves from Iceland to Ireland, from Greece to somewhere else. The banking crisis has been contained, but there are still many banks that need to nurse their exposures and be careful about new commitments. Above all it is a good idea to look again at yields and likely future returns. World shares are now offering below 2% by way of income. Yield (%) Japan 1.8 China 2.5 India 1.0 US (S&P 500) 2.3 UK 3.1 Germany 2.9 Source: FT Stock Market – Ratios There will be good profit and dividend growth this year, but there needs to be to justify current share price levels. In recent weeks we have added to property positions, where the yields were much more attractive. Buying into Asian REITs on a yield of 3.5%, and into Developed world and American property REITs on yields offering a good additional income to shares generally looked like an opportunity. Even these now have risen so the running income is at less attractive levels. UK shares are offering better yields than most advanced markets. We have strongly preferred Asian equities for the last five quarters, which has worked well as they have performed better. The large UK capitalisation shares in the large company indices are shares in multinationals trading mainly outside the UK, with plenty of foreign currency exposure in both assets and revenues to offset any fall in sterling. As a result we are no longer so negative on the FTSE 100, as the yield now does offer some comfort compared to other world markets that have risen by more. We remain negative on UK government bonds and the UK domestic economy. The election is postponing the necessary remedial action to tackle the public finances and sort out the banks. Election uncertainties, with some commentators and investors now worrying about a hung Parliament, are a further reason for caution.

What does an investor want?

05/03/2010 00:00:00

Sometimes it is a good idea to stand back from the day to day joys and fears of the markets and remind ourselves what we as investors are trying to do.Pension fund clients are wanting to pay future pensions, without facing a large extra bill to top up the fund. Charity clients want to pay future wages for their charity, and to command more resources in the years ahead than they can afford today, so they can maintain and preferably expand their charitable work. Rich individuals want to pass on a fund which has grown in real terms. They may want an income from their investment that rises by more than prices over their lifetimes. That is why, if asked, we suggest clients look at the returns we help them achieve against a real return index. If your fund, taking one year with another, is growing by 3-5% real, that means your fund is growing faster than wages. If you can sustain returns like that the pension fund will be able to pay the pensions, the charity will be able to do more and the rich individual will be able to live well and pass on a good inheritance to the next generation. In practise many clients want to feel they are doing better than this when markets are strong and rising, whilst many investment managers will want to warn clients that in bad years in markets they might have a negative return as many managers do not try to protect capital in a downturn. This has led to both sides often using measurement of an investment fund related to how markets are doing rather than to what is happening to the liabilities the fund is designed to meet. This year may prove to be a stiff challenge to both client and investment manager. We are not expecting large gains in most markets this year. The headwinds of rising interest rates, worries about inflation, damaged banks, the need to rein in monetary excess and the rolling sovereign debt crisis are likely to limit the upside. Returns on client funds are fast approaching the 3% real level for the whole year in just the first three months. I doubt, however, that clients would welcome locking the gains in and parking all the money in cash, as there is enough optimism around to want to stay invested. Last year we could have locked in a 5% real return well before the year end, but clients are doubtless glad we did not, as markets made rapid progress thereafter. The best advice I can offer on performance measurement is to keep in mind all the time the absolute rate of return you need to keep your fund ahead of its liabilities, and to be realistic about how high a rate of return you can earn. In the end rates of return are related to the growth rates of the underlying economies. We look at income levels and growth in income. Worldwide shares are currently offering under 2% by way of an initial income, which does not give you a lot of protection as interest rates and inflation rises. Rates of return in the credit boom of 2002-7 are not likely to be repeated in western debt laden economies. Eastern faster growing economies should produce higher rates of dividend growth, which is crucial to justifying current low share yields. Property income levels still seem to us to offer a better prospect, with a higher initial yield and reasonable growth prospects in many centres of the world. By all means look too at how well the managers run the portfolios against market indices and other benchmarks, but remember that outperforming by losing less than the market does not pay future bills.

Don't worry if you missed the gilt auction - there'll be more

02/03/2010 00:00:00

The UK Treasury could breathe a sigh of relief that today it managed to sell 2039 UK government debt relatively easily. They will recognise, however, that when you need to borrow £175 billion a year and refinance retiring debt you have to repeat that success week after week. The sum borrowed was less than a week's requirement. Meanwhile, the pound has taken more of the strain in the last few days, falling below $1.50 and giving up some ground against the Euro and other leading currencies. The problem with wishing to borrow so much is it leaves a government vulnerable to market whims and moods. In the last few days the currency market has taken fright from Opinion Polls, suggesting there could be a hung Parliament after May instead of a clear win for a new government. Markets hate uncertainties - though they also move and make money from them. Market participants want to be reassured that the next government, whatever its composition, is going to take reducing the deficit seriously. A hung Parliament might delay painful choices, so markets might decide to force their hand instead.If we look at the range of yields on European government bonds, we see that many countries now have to pay more than the 3.14% Germany is offering for a 10 year loan. Spain pays 3.84% today, Portugal 4.34% and Greece 6.12%. Outside the Euro zone, with no suggestion of German government support, the UK currently is paying 4.06% for 10 year money. Evercore Pan Asset has been warning for many months that UK gilts might not be a good investment. We have watched as yields have risen and prices fallen. At the same time the pound has also tended to fall. During the long period of quantitative easing the government and Bank of England bought up £198 billion of gilts, an amount in excess of the sums they needed to borrow at the time. Despite that extraordinary intervention, gilt prices tended to fall. We sold all fixed income gilts in portfolios brought to us where we had a full discretionary management mandate, preferring overseas and UK corporate bonds with higher yields. The overseas bonds also offer currency gain when the pound falls.Investors still holding UK government bonds must believe that government will soon rein in the spending and control the deficit, to limit the supply of such bonds. Additionally or alternatively they may believe that the current upturn in inflation is temporary, that there is substantial deflation around the corner, and that interest rates are going to stay low for a long time. These are possible scenarios, but not very likely ones.It seems more likely that the trend of interest rates is up from here. India and China have to tighten to curb inflation. UK and US short rates are at historically low levels and will have to go up some day. UK inflation may decline later this year, but the more the pound falls the more inflation we will import. The task of curbing the deficit requires spending cuts on a scale not seen before. The election delays action to grapple with this problem. We are sticking with our view that in these conditions UK government debt is a risky investment. Lending money to the UK government at a little over 4% does not look like a very enticing proposition. If you missed today's gilt auction and are worried about that, there will be another along any day soon. Meanwhile, those who went with the advice to be invested overseas in stronger economies and currencies are now making good money out of the latest devaluation of the pound. Every fall in the pound makes the UK less well off and imports some more inflation, as offsets to the improvement in export prices or profits.

Growing doubts?

26/02/2010 00:00:00

A few days ago we took profits on client positions in general commodity etfs. The surge in oil and metals prices from the lows had been impressive. Chinese restocking, excess Chinese, Indian and US liquidity and investors looking forward to recovery combined to increase commodity prices. The long term case for commodity investment remains strong. As Asia joins the world party, so demand for energy and metals will continue upwards. Adding a billion or two to the numbers of people in the world who can afford fridges, washing machines, cars and better homes will add greatly to the demand for basic commodities. In the short term we felt that markets had adjusted enough to the realities of the recovery, and were in danger of overdoing their enthusiasm given the stresses and strains that remain in the principal western economies. We are now at that point in the recovery where India and China have to take measures to curb inflationary pressures. Meanwhile news from the old world of Euroland, the UK, Japan and even the US is mixed at best. There are reasons to worry about the impact on world demand of the next phase of saving and debt repayment in the overextended private sectors of the USA and the UK. The US, UK and Euroland will be showing substantial private sector surpluses this year. Companies and individuals are much more reluctant to get into debt than they were in 2006-7. Money is still tight and scarce for many in the business world or for those seeking a mortgage. As a result we should expect subdued consumption growth. The big driver of the 2007 boom, debt fuelled consumption in many parts of the west, will not be the same force in the recovery. The tensions this year arise from the wish of the UK, the US, the Club Med and other overextended economies to join the list of countries that follow a path of export led growth. Japan, China and Germany are reluctant to give up this model which has served them well in the past, so all too many countries are now seeking to export for growth, against the background of a world market with insufficient demand for all their output. Countries are seeking competitive devaluations, or are sticking with currency pegs like the Chinese one to try to avoid revaluation. How will these tensions be resolved? The dash to the bottom in the currency race will ultimately only be successful for the worst managed economies. We expect China to give some ground on the yuan in due course this year. Individual countries will be forced in to greater rectitude in their public finances by market pressures, as we are seeing with Ireland and Greece. Meanwhile the new vogue amongst banking regulators for greater prudence places a lid on the growth rates of the western private sectors. We should expect hesitations and worries about the pace of the recovery, and concerns about the overall world economic performance, all the time private sectors are saving more and banks are being forced to hold more cash and capital. It seemed to us a good idea to take a little risk off the table whilst markets digest some of the worrying news on activity and confidence that is now coming out.

City Blues?

23/02/2010 00:00:00

The City and British financial establishment are worried. Recently 20 senior economists, including some who know the Treasury and Bank well, wrote a letter to the Sunday Times saying that the Uk needed to curb its deficit. The authorities were defended by more than 60 in a subsequent letter to the FT. This morning a couple of City heavyweights have questioned the Bank's anti inflation record of the last decade, pointing out that there has been a bias to underestimate the UK inflation rate when forecasting and to end up with higher inflation rates than the target dictates. The City and the British economics establishment is usually a consensual club. Its members are normally at one on the big issues of how the establishment architecture should be constructed and what judgement calls the main players should make. Consensus thinking can lead to complacency, to similar forecasts from all the main players, and at times has led to disaster. In the 1980s the establishment wanted the UK to join the Exchange Rate Mechanism. It took some time, as there were a few of us mounting a long rearguard action to prevent such a move, as we thought it would be destabilising and ultimately self defeating. Even Margaret Thatcher, a natural ERM sceptic, gave in to the pressure eventually. The ERM gave us boom and bust. It first required us to set interest rates that were too low, and to print pounds, to try to keep the value of the pound down. This gave us an inflationary boom. Then it forced us to hike interest rates too high and to buy in pounds, squeezing credit too much and giving us a bust. Establishment figures argued that if we had gone in at a different rate it might have worked better. In the end most prudently walked away from the traffic accident they had helped cause, sensibly forgetting their passionate support for this independent auto pilot system which was meant to give us stability. In the late 1990s the Establishment invented a new version of the independent ERM. They gave us the so called independent Bank of England. In fairness to the advocates, they did not recommend stripping the Bank of so many powers in the way the new government decided to do. However, instead of having a row at the beginning and warning that a Central Bank stripped of banking regulation and government debt issue would struggle to understand all the forces in the money markets it had to supervise, they went along with the idea that we were in a new era of independent central banking which would create stability. We now know that this system also gave us boom and bust. Indeed, it gave us a more violent cycle than the ERM. Why did the independent Bank fail to control inflation, and how did it end up presiding over such a violent ride? Why did the politicians override the ERM sooner than they dared publically override the independent Bank? The speed of the eventual disaster in the ERM forced politicians hands to abandon the experiment. In 2008 the Chancellor effectively overrode the independent system with the international agreement to cut rates, but was keen to present it as business as usual. The MPC met to settle the rates as if nothing had happened. It is true that the US did something similar to the UK this cycle, but it is not a satisfactory explanation to say we were swamped by the US influence. Other trading partners of the USA followed very different courses on output and inflation. The US downturn was less severe than the UK's. The UK policy errors that did most damage were the interest rates set by the Bank based on their theory of the output gap, and the attitude taken to banking cash and capital by the banking regulators. The Bank of England held interest rates too low for too long, reassured by cheap imports temporarily keeping the inflation rate down and by its calculations of how much spare capacity there was in the economy. The Treasury egged this on by claiming that the UK's trend rate of growth rose to a sustainable 2.75% a year by 2007. Subsequently they held rates too high for too long. It is difficult judging how big an output gap there is at any given time. Capacity can be easily destroyed. Once a firm has made the staff redundant the capacity has gone. It takes an act of confidence to rehire staff and set the factory to work again. If a business has been so starved of bank finance it has squeezed its stocks dramatically, its immediate ability to produce more is constrained by lack of raw materials and parts. In this cycle pricing behaviour has changed from some of the text book analysis. Some businesses have said that as demand has fallen so much it costs them more per unit to supply, so prices have to go up. The falling pound and rising import prices gives them more cover to do this. Meanwhile the banking regulators are squeezing bank balance sheets and therefore private sector bank finance hard. These strange conditions have given us lively inflation against the backdrop of recession and poor final demand. The squeeze on people's living standards is now intense, with practically no overall wage growth in the private sector allied to sharp price rises. This is now spreading to the public sector. Yesterday I was asked to make some predictions about investment in the UK for a group of Charity investors. I had to say that there are better prospects elsewhere at the moment. The UK has large imbalances in its economy to correct. It is spending and borrowing too much and saving, exporting and investing too little. Its public sector deficit is unsustainable, and its banks being squeezed by regulatory pressures. When the UK establishment is as worried as it is currently is, you too should be worried.

Reasons to be nervous

19/02/2010 00:00:00

I feel very nervous about investments.Markets have had a good week. January’s modest losses have more or less been erased. The Fed has announced we should expect better growth this year in the USA. The Greek crisis has not deteriorated further. Barclays announced bumper profits and a much stronger balance sheet. Many in the markets have gone back to thinking this is a normal cycle, where re-stocking will give way to increased final demand. The recovery may be slower and longer, but there will be enough easy money around to ensure a recovery of sorts. In this situation markets should afford modest positive returns for patient investors. So why do I feel nervous? I am concerned because the main imbalances in the world economy that lay behind the crash are not being sorted out rapidly.Interest rates have to rise from here. In China they have made a start towards normalising credit conditions by restricting bank lending. In India rapid inflation requires higher interest rates to cool it all. Australia has started raising rates. The USA made a first modest step with a 0.25% increase in the discount rate for banks. In the UK, Greece and elsewhere high borrowing is leading to higher government bond yields.Banks have been propped up by government actions, and some banks are trading themselves out of difficulty by making huge profits in their investment banking arms. In both the UK and the US there remain concealed big problems with debts secured on property. As Regulators demand more cash and capital for any level of business, so returns on banking capital fall and less money is available for business to expand. The Euro is devaluing gently as investors reappraise the risks involved in a currency based on very different economies and public debt levels. The Euro sovereign debt crisis may not be over, as the countries at risk may not yet have taken enough action to curb their deficits. The UK public deficit is growing rapidly as expected. That too may not be sustainable short of convincing government action to tame it. The Japanese, Germans and Chinese still want to run their economies on an export-led model, at a time when their principal customers in the West are having to rein in their appetite for more consumption financed by borrowing. The US and UK consumer is having to repay debt or make do with lower earnings as the recession forces more into part time working or unemployment.So where should an investor go from here? We still think there is more risk in the heavily borrowed and slow growth territories than in the fast growth areas of the world. We remain negative on gilts and some other European country bonds, as we expect further rises in interest rates to reflect the deficit risks. It is time to have a balanced portfolio investing in markets where there is sustainable and growing income. It is time to hold less risk than in 2009 and to expect less good returns. 2010 is proving to be hard work for investors, as we feared. Asian property, corporate bonds and some emerging market equity is probably about as good as it gets.

The crucial decisions investors and trustees make without realising

16/02/2010 00:00:00

I have met a number of individual investors and charity trustees in recent days who spend a lot of time and energy on choosing managers and specialist funds, but who effectively undertake their own asset allocation.Some of them seem unaware that they are making the asset allocation decisions. They have some money, so they consider a range of options, judging on a particular day the right combination of asset and manager and whether to buy into another fund. Sometimes the managers come to them, inspiring them to think again about their current portfolio. Sometimes they go to the managers, because they have cash to invest or they have time and interest to think about their fund that week.This can be a very dear way of getting things wrong. The asset classes and funds they choose are often expensively managed. They may make a commitment when it is not a good time to add to that particular asset class because it has become too fashionable. It might have been sensible to make a bigger commitment to commodities in the second half of 2009 when China was stockpiling and easy money was the order of the day. In January 2010 when China was reining in some of her buying and lending it looked a bit different. It may have been good to hold property unit funds in 2006, but by 2007 these were dangerously exposed to a market about to fall heavily. The funds often turned out to be very illiquid, so you couldn't get out when you wished. Buying hedge funds to have something in the portfolio that was not going to go up and down with volatile share markets sounded good before the Crunch, but then many hedge funds disappointed and fell in 2008 when they should have detached from the general chaos. The evidence is very strong that what matters most to successful portfolio performance is the asset allocation. There is no one right asset allocation for all seasons, and no one right answer for your particular fund. The huge changes in public policy between 2006 and 2010 have had a large impact on asset values. We have lurched from easy money to tight money to easy money to difficult monetary conditions in the space of just four years. The prices and values of the main asset classes have been very volatile. Old trading ranges have been blown apart by violent market movements. The Credit Crunch sorely tested many investors’ appetite for risk and revealed new weaknesses in risky assets. You may have taken advice and chosen a sensible asset allocation at the beginning of 2007, but that was quite inappropriate by the autumn of 2007 given the big change in banks and economies. That's why we think you should spend more of your investment advice budget on asset allocation than on anything else. The best way to cut your total fees is to index the investments you make in shares. The advantage of having an asset allocation adviser or manager is then you know the big decisions that matter are constantly supervised, and your attention drawn to what will actually make or lose you lots of money. Trustees have a duty of care to look after the money under their charge. They do need to show they have taken proper advice on the overall balance of the fund, and understand that that needs to be done regularly as values and markets change so rapidly.

Is Greece a Trojan horse for the debt crisis?

12/02/2010 00:00:00

With Greece nestling in the Euro zone, the EU Euro summiteers yesterday tried to give the impression that there would be gifts for the Greeks to save them within the zone. There was no detail, however. It was all spin and mood music, no deals, no loans with conditions, nothing save stern words on how Greece would at last control her deficit. France and Germany know words are cheap. They were full of comfort and strength, but they did not sign any cheques. Nor should they. The truth is many European countries have borrowed too much and are still borrowing too much. If a country which is weak financially has to go to the aid of another country which is even weaker, you do not end up with two strong countries, but with two weak ones. The danger in a weakened Euro zone is that if one country needs a big bail out, it may start to drag down others and in turn undermine the whole system. The bizarre thing in the whole debate is how many people just assert that cutting public spending by 10% is too much, too cruel, impossible. Given the enormous waste and inefficiency of European public sectors, cutting by 10% is technically very easy. If they really do believe in solidarity all they need do is cut all the salaries, other than the lowest paid, by 10% and put on a staff freeze: the costs will come roaring down. It is high time the public sector joined the reality that parts of the private sector has had to endure for a couple of years. There is no way out of a debt crisis other than curbing spending and repaying some debt. The longer they delay the inevitable, the worse the crisis will be. Greece is today in the front line of the battle between the markets and overspending governments. Tomorrow it could move on to include Portugal, Spain, even the UK. The markets will want to extract higher interest rates from governments that borrow too much. They will want to force a change of conduct they believe in. Just as governments were all too ready to preach to banks and the private sector about the perils of borrowing too much, so markets are now in a mood to do the same back to governments. The sovereign debt crisis may still be in its early phases. UK debt is no longer rated alongside Germany's, with the UK having to pay more than Germany to borrow longer-term money. Greek debt is now rated well below fellow Euro members' debt, reflecting market worries about the level of Greek state borrowing. We expect more market pressures against all the weaker states financially. That is why we have avoided or sold UK government bonds and continue to recommend that investors stay out of all sovereign debt bonds from countries with large deficits and no credible and detailed deficit reduction programmes. The move to higher government bond rates to reflect risk is still underway and has further to go. Country Ten Year Government Bond Bid Yield France 3.56 Germany 3.24 Greece 5.99 Italy 4.04 Japan 1.33 Portugal 4.42 Spain 4.03 UK 4.02 US 3.73Source: Financial Times. Data as at 11/02/10

Euro angst

09/02/2010 00:00:00

When the Euro was set up some commentators warned that the economies needed to be brought into line with each other before binding them in with a single currency. The creators of the currency appreciated that they needed internal discipline. If countries came in with too large a stock of debt they could free ride on the backs of the more prudent countries. They could refinance their debts at lower average interest rates which reflected the credit worthiness of the zone as a whole. They decided to let this happen up to a generous upper limit. They also understood that if a country started to run a high annual deficit for any period they too would be free riding on the better financial disciplines of the area as a whole. Their conduct would tend to raise the average interest rate for all a little, but reduce their rate by rather more. If a group of countries persisted in borrowing too much, the effects would be more marked. In order to combat this problem the founders put in place rules which said that any individual country was not to borrow more than 3% of its National Income in any given year. They also left the markets believing that each individual country was still responsible for its own credit worthiness within the system. There was no automatic guarantee to lend money to a country in trouble at the average Euro government rate, nor was there any promise that if a country could no longer pay the interest or the repayments on its debt the other states would definitely foot the bill. Instead there was studied ambiguity, giving the zone the power to intervene, to lend or grant money to countries in trouble if the others thought that a good idea. We are now into the second serious crisis of the Euro. The first was their share of the world banking crisis, which on the whole they handled better than the US and UK. The second revolves around the deteriorating credit rating of several Euro members on the periphery of the Euro area. The Euro zone so far has shown a firm touch with Ireland, which obligingly and correctly cut its spending sharply to reassure markets, and weakly with Greece, which so far has failed to do enough to reassure markets. The Euro zone masters have failed to insist that Greece does cut its deficit, whilst also failing so far to come up with subsidies and loans to let them off the hook for the time being. Most of the countries in the Eurozone have large public sectors. Many have stretched the national credit during the downturn. Markets are already worrying about Portugal and Spain before the Greek issues are settled. The Eurozone is going to discover that they can only make a continuing success of their currency if they are strict about the discipline. If they had enforced the 3% budget deficit limit – maybe with a cyclical adjustment for the world slump – they would not be in this awkward position now. If they told Greece more firmly that there is no money for them and they have to repair their own credit rating on world markets to carry on borrowing, that would help sure up the currency and would send a strong message to other overspending Euro states that they had better take earlier action with their budgets before the markets upset them. The Euro authorities may of course want to see the Euro fall a bit more. Germany is finding it difficult to export against the current world trade headwinds and in the face of Chinese competition. They are going about engineering a devaluation in the right way by appearing to dither over whether to support ill discipline in their ranks or not. We do not expect the zone to so misjudge it that the zone itself falls apart, but the pressures are building up in markets. Meanwhile all real asset prices are under some pressure, as world liquidity is being squeezed by the sharp corrective action in China and the cessation of new quantitative easing in the US and UK. We remain concerned about prospects in highly borrowed countries, avoiding sovereign debt in them and preferring claims on real assets in parts of the world that can still grow at good rates despite the general sluggishness of the recovery.

The rolling government debt crisis

05/02/2010 00:00:00

Readers of this site will not be surprised that world markets are starting to tell individual governments that they are borrowing too much. If there has been a surprise, it has been the delay before markets wake up and force changes on reluctant administrations. The sloth of markets to say "No" to excess will just ensure that as each country crisis comes it will be bigger and the reckoning heavier, because each country will have borrowed even more. Iceland, Ireland and the Baltic Republics had their medicine administered sometime ago. They have each been forced into spending cuts, and have to pay more for their loans. Last week the storm surrounded Greece. Yesterday the pressures began to envelop Spain and Portugal. This is the period of maximum pressure on the Euro. Markets are saying to countries in the Euro who have wandered far away from the discipline of keeping public borrowing down to an annual 3% of their national incomes, they need to cut spending. If they refuse, they need to seek loans and subsidies from the better run members of the Euro area, as the markets are no longer willing to lend to them at German rates. It turns out they are not part of an integrated money union where all are for one and each is for all. Each Euro member has its own deficit problems, and each has its own credit rating. So it will remain unless and until they each guarantee each other's borrowings and freely transfer cash from the richest to the poorest, from the best run to the worst run, as needed. Germany is understandably reluctant to do that at the best of times. When she is wrestling with her own recession and deficit problems she is unlikely to bail them all out to the extent needed. The UK would be unwise to think different rules apply to us because the UK is not in the Euro, for one very good reason. It would be foolish of us to say we welcome being out of the Euro to give us the flexibility to borrow to excess, to borrow more than the prisoner members of the Euro, Greece, Portugal, Spain and Ireland. It does not matter whether you are in or out of the Euro when it comes to world market reactions to how much money you can borrow. The UK will not escape the government debt crisis. It has been living on borrowed time for too long. What can happen to Greece, Portugal and Spain today, can easily happen to the UK tomorrow. Far from enjoying the collapse of the Euro against the dollar and the good questions now being raised over the whole shaky edifice of the single currency, the UK should look to its own problems. The UK has borrowed too much already, and is borrowing far too much going forward. The Bank "paused" quantitative easing yesterday, to let the bubble in government debt down gently. From here it gets tougher to borrow all the money the government needs. If the UK government does not take the right budgetary action soon, it will be the UK's turn to be tossed around in the world's bond markets. The end of that process is for all of us to have to pay more tax to pay the rising government interest bills as the rates go up. At a certain point, just as happened in Ireland and now in Greece, the government has to cut spending. We remain of the view that investors should avoid UK government fixed income debt where we expect more bad news ahead. We have also avoided country based share investment in the major developed economies, which are now suffering from the backwash of this rolling government debt crisis. It is a time for balanced and cautious investment. As we feared, this year is likely to produce much lower returns than 2009 as the long aftermath of the banking crisis is compounded by the government borrowing crises now becoming the main topic of market conversation.

Fiscal discipline needed to avoid Greek tragedy

02/02/2010 00:00:00

Last week markets took fright at the mountain of money Greece wants to borrow to pay its government bills. It needs to borrow about the same relative to its National Income as the UK. The markets have pushed the price of Greek government bonds down, so Greece now has to pay twice as much interest as Germany to borrow the same number of Euros for ten years. Greece cannot devalue within the Euro. The UK has already knocked one fifth off the amount it has to repay foreigners who lent it sterling cash by devaluing by a fifth over the last couple of years. Greece is saddled with paying back Euros, which have been more stable against the strong currencies of the lending nations. There are five possible options for Greece from here: 1. Leave the Euro and devalue. That cuts the amount of real money they would need to pay back, would make their exports more competitive and their imports dearer, leading to a shift from consuming too much at home to working harder for foreigners abroad. They would still need to cut their deficit by cutting spending, as they would still need to borrow to pay some of the bills and they would no longer be able to offer Euros for repayment. Without the backing of the Euro they would either have to pay a higher interest rate, or cut spending substantially to rekindle confidence. 2. Stay in the Euro and accept the discipline of the club. They are meant to keep borrowing down to 3% of their income. Instead it has soared to 12.7%. They could cut their spending substantially, restoring confidence and limiting the amount they need to borrow. Their interest rates would return to similar levels to German ones once confidence was restored, but that could take time and long period of discipline. 3. The strong countries within the Euro zone could lend them the money they want to borrow on better terms than the market, or give them grants to see them through this bad patch. It is traditional in mature currency unions where there is also a single government for the richer parts of the union to send tax revenues to the poorer parts to help them. 4. There could be a deal. Germany and her friends within the Euro zone could agree a package, where Greece cuts her deficit by spending cuts and then is eligible for some grants, loans or subsidies to make up the rest. 5. They could all decide to do nothing. Greece would have to pay more to borrow internationally, and would gradually have to take action to curb the deficit. Otherwise the interest rate she had to pay might become so penal the markets forced a crisis, requiring action under one of the four options above. I think Option one, leaving the Euro, is unlikely. Greece is keen to stay in, probably hoping for protection from her own folly by belonging to the larger club, and hoping against hope for more loans and subsidies from within. Whilst some in Germany and France might see going back to a core Euro as an attractive and more stable option, the overall balance of opinion in the EU is likely to want to keep Greece in. If Greece left, the positions of Spain, Portugal and some others would also be in question. It could lead to a messy unravelling of the wider Euro project. I suspect Option 5 is also running out of room, as the markets are close now to forcing action to correct the deficit or to force a bail out for Greece. I would think Germany unlikely to simply offer to fund the excessive Greek deficit. It would be an open invitation to all the other ill disciplined Euro members to run up big debts and ask the centre for easy money to pay the bills. It would also start to place too much strain on Germany herself, as Germany is not without her own economic problems. So that leaves the two options of tackling the deficit herself or doing so with European help and assistance for meeting various targets. The whole saga shows the problem of premature currency union without proper arrangements in place for transfer payments and common fiscal policy. The Euro is becoming a system to try to impose disciplined policies on the periphery, as Ireland, Greece, Spain, Portugal and even Italy have to rein in their excesses to live within the Euro scheme. Their reluctance to do so creates unemployment and lower incomes in each of them, and will generate a series of debt crises and economic crises as they push against the need to control spending. Greece has a simple choice. Either live with German discipline, or run an expansive fiscal and economic policy and be at the mercy of markets. The Euro is not the free lunch some members thought it was going to be. It does not give a right to badly run countries to borrow at German rates of interest. You cannot guarantee single currency success unless you first create a single fiscal and economic policy. The EU thought that budget discipline could be administered by guidelines and rules, but several members have greatly exceeded the limits the EU wanted to impose on debt levels. Currency markets have cut the value of the Euro against the dollar as a result of these events. Some even in Germany will be relieved, as even German exporters have found the recent level of the Euro tough going in limited world export markets. The Eurozone continues to have problems, both as a result of the very wide range of fiscal policies being followed, and from the ageing population. We recommend keeping out of shares in this region whilst they hammer out a solution to the Greek problem, and think about the plights of Spain, Portugal and Ireland.

A Divided World

29/01/2010 00:00:00

As we feared 2010 is a more difficult year for investors. It is not clearly a crisis year like 2008, nor clearly a sharp recovery year for financial assets like 2009. Markets are jittery, and governments are unsure about what to do.The world is still badly divided. There are the successful exporters, led by China, Japan and Germany, and the heavy importers, led by the US and the UK. The former need to import more and consume more at home, the latter need to export more and consume less. There are limited signs that the US and UK will export more following devaluations, but little sign of a surge in imports into Japan and Germany. There are the fast growth countries, led by China and India, where inflation is becoming a problem, such is the strength of their stimuli and recovery. There are the low or no growth economies led by the UK, but including Japan and Euroland.The divisions are no longer clear cut. All the world’s major economies face a range of difficult problems. We can perhaps best identify them by looking at several issues.Firstly, there are those countries that have inflation problems. India has a serious problem, with a 16% rate. China has sharply accelerating inflation. So does the UK, but the authorities think that will prove temporary. The usual policy response to higher inflation is higher interest rates and monetary tightening. China has just hinted at this. She will do more, but I suspect she is also very afraid of tipping the economy back into downturn by doing too much. She will probably do more by way of controlling the volumes of bank lending to various sectors. India needs to do more more rapidly. The UK is likely to be less aggressive with its loose money policy from here than over the last extended period of quantitative easing, despite the poor performance on growth. There are also countries like Japan that have deflationary problems. A shortage of domestic demand is keeping prices well down. Demand is also depressed in core Euroland. The normal response would be to spend and borrow more. Unfortunately for Japan past governments have done lots of that, but it has not succeeded in expanding demand to lift the economy out of torpor. It has left the economy heavily indebted. Germany is philosophically ill disposed to borrowing more to fire consumption. The Euro bank seems keener to relax by allowing some modest devaluation, to make German and other EU exports more competitive again.There are highly borrowed countries including the US, UK and Japan which would like more activity but have to acknowledge there are limits to how much their states can borrow from here. Both the US and UK will have to commence deficit reduction programmes soon, whilst Japan will probably pause before another surge in government borrowing, as it has not worked in the past.So we have a recipe for world stagflation. The hot areas will have to cool down a bit, whilst the cold areas each have problems with administering more stimulus or finding one which might work.We expect a fitful and slow recovery overall. India and China will head the growth tables amongst the larger countries. The US, and more especially the UK, Spain, Ireland Iceland and Greece, will have to squeeze their public sectors to control their state debts.Australia has led the way with higher interest rates. There are likely to be higher interest rates in India and Korea, monetary tightening in China, and market forced interest rate increases may continue in the UK as quantitative easing ends.The best policy mix would be easy money and lower public deficits, to stimulate growth. This will prove elusive as a formula for many territories. The banks are making good money again out of the extraordinary conditions, but banking regulators are still tightening around the world, often offsetting the other expansionary measures taken by governments. If governments are serious about another round of bank bashing because it is such good politics, it could restrain lending and demand more. We still recommend balanced portfolios for these more difficult conditions. It is going to be much more difficult earning good returns than it was in either 2008 when cash was so attractive, or 2009 when shares were cheap. We favour the emphasis on assets that offer reasonable income, including good quality corporate bonds and property. Although Asia has its problems, they are the problems of recovery rather than the problems of past excess and slow growth, so we still prefer that area for the equity exposure in growth-oriented funds.

Will the US President sink the bull market?

26/01/2010 00:00:00

Markets nosedived on Mr Obama’s call to arms against Wall Street. Investors feared his threat of regulation and bank splitting could damage bank profits and the wider economy. The President’s wish to split off hedge funds, proprietary trading and venture capital from utility banking on the High Street could be done. If he just tries to do it in one country, even a large and powerful country like the USA, the mega banks will simply shift their ownership of these areas elsewhere. If the US claims extraterritorial jurisdiction, then the mega banks based in the US could switch their HQs to another overseas territory. If he still pursues them, they could split their capital structures.If all the main banking jurisdictions of the world agree some new Basel accord on the subject it is likely the big banks would get the message. They could sell off their private equity, trading and hedge fund arms as separate companies. They could split themselves into investment banks containing the “naughty” business as defined by the President, and utility banks. All this implies two things that I do not agree with. The first is, it suggests the three specified areas were the ones that caused the problems, whereas in many cases this is not true. Secondly it implies that future bailouts of utility banks is acceptable. Surely we ought to be seeking a world where bailouts are not needed? Why does the taxpayer have to face more pain for banking incompetence and Central Bank error?What we ought to be discussing is how to regulate cash and capital by banks in a way which makes failure less likely. We need to discuss why the main Central Banks got it so wrong, why they kept interest rates too low for too long to create the bubble, then held them too high for too long to create the slump. We need to understand they ran a boom and bust policy, and both phases were wrong. We need to find people to run the Central Banks who don’t drive by looking in the rear view mirror, but who can think ahead.If we stick with the regulation of commercial banks, the Regulator could make it clear their guarantees only extended to the utility bank subsidiary in their jurisdiction. If each national utility bank was separately accounted it could remain solvent and independent if the rest of the Group went down. Alternatively, we could just strengthen deposit insurance so all who we wish to protect in a crash have the reassurance that their money is safe. Under either of these models there is no need for a run on the bank to add to its other troubles.In the UK we need to split up RBS and Lloyds whilst they still have large public stakes. If the minority shareholders do not like it then they must arrange for buyers to take all the government’s shares at a profit for the taxpayer to allow them to call the shots. We need to strengthen our competition policy, by explaining to our Competition authority that the aim of policy is to get much more competition into High Street banking in the UK, supporting the policy of splitting RBS and Lloyds.There is still a need to regulate cash and capital. It is true there is no evidence from the recent past that the Regulators knew how to do it. We should try again. All banks and financial businesses taking positions on their balance sheets and offering to pay people their money back at some point in the future should be expected to keep minimum levels of cash and capital. These levels should normally be higher than they were in 2007. In the short term they should be lower, as we need to generate more loans and financial activity to help the recovery. Sometime we need to come off quantitative easing and very low official interest rates. This is just a money go round to let the government spend too much, and to allow the banks to earn easy money. It does not help the rest of the economy, still struggling with too little credit at too high a price as a result.For Mr Obama, it was bash or be bashed. The US public – like the UK public – were not happy that so much of their money was tossed into propping up banks, or put at risk underwriting them. They became livid when those same banks, a year later, were busy paying their top executives mega bucks in bonuses as if nothing had gone wrong, as if they had earned the money by their own great talents.Mr Obama has just had a very bruising encounter with the US electors. Both the winning and losing candidates in Massachusetts stated that the big issue was Obama’s very own unpopular health care plan. Mr Obama says he is quietly parking or delaying the offending big idea. Now he needs to change the topic and find people and institutions more unpopular than himself. Enter the bankers.Like many modern politicians Mr Obama is good at moods and sound bites. He ought to be, as no doubt they spend a fortune tapping the mood and polling the words. So far he has found it more difficult when it comes to executive action, unable to develop honed policy and put it through. Closing Guantanamo was a great sound bite, but a year on it hasn’t happened. Changing the approach to the Middle East with a new kind of foreign policy sounded good, but the intensified Afghan war looks more like Bush mark two. Offering healthcare to those who could not afford it sounded heroic. Instead many Middle Americans feel threatened with higher cost health care and higher taxes.So what is Mr Obama offering for his new banking policy? We do not know. There were two short paragraphs, designed to send a single message – he welcomes a fight with Wall Street. It worked with the tabloids, but it is scarcely a considered policy towards banking regulation.He also implied that some banks were too big, without defining how big a bank should be and without naming the ones he had in mind. He wants big banks to get out of various activities.If he had bothered to think about the crisis we have lived through, he would have noticed that the two biggest catastrophes in the US were Freddie and Fannie. These are both specialist mortgage banks, brought down by advancing too much mortgage to too many people. His remedies do not tackle that issue. He might have spotted that Lehmans went bust. That was a specialist investment bank, that would also be unaffected by his two paragraphs. If he had looked across to the UK he would have seen that Northern Rock, Alliance and Leicester and Bradford and Bingley were also all specialist mortgage banks.Out of his sound bites could come a sensible policy. As readers will know, I do want the two UK state owned mega banks broken up. They were too big to fail and too big to bail. The breakup of banks that needed taxpayer support and might need it in the future is a good idea. Ensuring that in future they have more capital at the dangerous stages of the cycle would also be a good idea.Markets should not worry too much about these rash statements from the President. They were more political than considered policy. It would be surprising if the US rushed into tough regulation before finding out what the rest of the world will do. The Sarbanes Oxley Act handed large areas of financial business on a plate to London. I doubt London will be so lucky this time round.

The immutable rise of the BRICs

22/01/2010 00:00:00

A few years ago the world’s four largest economies were the USA, Japan, Germany and the UK.* We have long warned readers of the UK’s spectacular fall from grace, which is still continuing. The UK is now in sixth place and still declining. The sharp selloff in sterling last year, allied to the contraction in GDP, has propelled the UK below France.The rise of China will also be familiar to visitors to this site. China has stormed up the league tables, to reach the second slot in a table of the world’s largest economies. This has mainly been achieved by growth rates of close to 10% per annum, based on her huge success as an exporter.When I wrote Superpower Struggles in 2005 I forecast:“A much more effective competitor to the US, potentially a major global player, is rising in the Far East. […] It (the Chinese economy) has already overtaken Italy to become the world’s sixth largest economy, and will soon pass the size of France and the UK at market exchange rates. By the next decade it will be larger than Germany, in third place, poised to overtake Japan.”The forecast was almost too cautious, as China only waited for three weeks of the new decade before announcing her second place. Before the latest phase of China’s rise and the UK’s decline, the top four economies of the world had a certain balance. The US and UK were heavy borrowers. Their consumers sucked in imports from the successful exporters. Their banks and borrowers drew on capital from the savings of the successful exporting economies. In contrast, Germany and Japan were economies driven by savings and manufacture for export. It is true that the US was a lot bigger than the other three, but for a number of years it was a relatively stable system which let the Anglo Saxons borrow and spend, and the others save and sell overseas. China’s rise now has an important impact on the world economy. China’s huge stimulus last year helped end the recession in many parts of the world. Now China’s early wish to rein in bank lending before the bubbles grow too big is sending shivers around world markets as changes in the Fed’s attitude always do. The arrival of another export led high savings economy at the top of the tables makes it even more competitive for Germany and Japan, struggling to handle the sharp downturn in demand triggered by the bursting of the borrowing bubble on both sides of the Atlantic.Nor should we think China’s arrival in second slot** marks an end to this period of rapid change. Whilst it is going to take a good few years for even China to catch up with the size of the US economy, we could well see India from just outside the top ten and Brazil from tenth slot advance up the rankings. Going in the opposite direction could well be Spain and Italy as well as the UK, as all suffer from economic weakness in an ever more competitive world.What lessons should we draw from all this? The first is that this remains the age of the Pacific. Two of the largest economic gainers are and will be China and India. There is a decisive shift in economic power occurring from old world and western world, to new world and eastern world. It could have a lot further to go, as these emerging economies have many more people to shift from agriculture to more productive activities. They remain with low incomes per head, able to apply existing technology to catching up with the West.The second is that the big gulf between the exporters and the borrowers has become too large and is now a cause of instability. Adjustment hurts both sides. Indeed, Germany and Japan, the exporters, took a bigger hit than the leading borrower, the USA, during the last downturn. From here we think the borrowers are going into leaner times, as they have to rein in some of their excess consumption and borrowing.The third is that there remains too much capacity around the world. The older and dearer exporting countries, like Germany and Japan, will probably struggle more to adjust than the newer and cheaper exporters like China.It is possible to make a very bearish case from here. The western banks have not been fully mended. Western states, especially the UK, Ireland, and Greece have extended their own credit too far. There is too much export capacity in the world. China is having to cut bank credit very early in the cycle because her stimulus was so huge and had such an impact on her domestic economy. However, we think that whilst it is going to be tougher making money from risk assets in 2010 than in 2009, the authorities in the major countries may take further action to avoid another meltdown or sharp downturn, or avoid too much damaging action. Meanwhile cash returns are still very poor, discouraging investors from going into cash.We still prefer to be with the winners, on the side of history. There are many complexities facing China and the other emerging markets from here, but they do not seem to us to be so worrying as the problems which remain un-tackled in some mature western economies where difficult decisions have been delayed rather than avoided. * Based on GDP at current prices, Source: International Monetary Fund, World Economic Outlook Database [1999 figures])** Based on GDP (PPP), Source: World Bank [2008 figures])

China wobbles

19/01/2010 00:00:00

We have been bulls of China. This super competitive economy has become the world’s most powerful exporter. China takes the waiting out of wanting for many Western consumers, by delivering good quality product at affordable prices. The Chinese authorities have kept the value of their currency down to add competitive edge. Thousands of Chinese migrate from country to town to swell the industrial workforce each month. They are highly motivated. Talent in China tends to gravitate to industry and enterprise, as the media and government machines are still highly centrally controlled and do not value novelty or dissent.Towards the end of 2008 the Chinese government became alarmed by the severity of the downturn in demand, brought on by the financial crash in their major western markets. Stories circulated in the western media saying Beijing was worried by the social consequences of the sharp downturn and the unemployment that resulted from it. They feared unrest.As a result the Chinese government embarked on the most massive stimulus programme relative to the size of their economy of any major country. They could afford to. The good years of export success had given China $2 trillion in reserves. An economy used to growing at more than 8% a year has many more options than more mature western economies growing at 1-2%.The huge stimulus worked. They expanded credit growth, money supply and the public deficit. The government spent more, and the state influenced banks lent more to increase private demand. Within a matter of months asset prices of shares and properties started to surge. We moved from being all in cash for clients, to holding good positions either in China directly or in Asia ex Japan which gave us representation to China.Recently there have been a couple of important wobbles we need to think about. The first highlighted the extreme fiscal and monetary response they have made. Property prices and general prices have risen, with the danger of too much asset price inflation in particular. As a result the Chinese authorities have demanded the banks hold more capital, and have sent first signals about monetary tightening. Stocks immediately reacted downwards. Markets expect more monetary tightening to come, with higher interest rates in due course.The second highlighted the Chinese twin system of progressive economic liberalisation allied to central political control in a single party state. Google, an investor in China who had responded to the growing economic freedoms, suddenly pulled out. The company did so in protest at state interference in Chinese people’s email accounts, wanting to limit internet freedom and spy on citizens through their computer use.Some will argue that these two events suggest Chinese shares have gone high enough. Why not take your profit, where you have one, and turn your back on a country struggling to reassert monetary control after some excess? Should you not recognise the danger of a country that cannot use the full range of the internet and its providers owing to its wish to be authoritarian?I think it is still premature to take that view. The Chinese authorities are unlikely to tighten so much that they abort their recovery or bring the present boom grinding to a premature halt. Memories of the 2008 recession are still too recent. I would also not put too much money on as large and dynamic population as China’s putting up with censorship of the internet entirely. We are still running our positions in China. In common with our general view, we think 2010 is going to be a less easy year for making money than 2009. We think there is still some scope left from worldwide easy money. China is still going to grow much faster than the western economies, despite the wobbles and bumps on the way. It's not always wrong to be a bull in a china shop.

Squeezing banks will mean squeezing lending

15/01/2010 00:00:00

The US President's decision to tax banks is a blunt instrument. His tax is a levy on banks' liabilities other than deposits from the public. It will encourage banks to have smaller balance sheets. That makes it a way of limiting growth or acting as an incentive to reducing banks’ assets, as assets equal liabilities. Banks' assets are Joe Public's mortgages, company loans for investment and working capital, and other borrowings by Main Street. This is the opposite of what is needed.I hasten to add that I am not today riding to the help of overpaid bankers, or acting as an apologist for the bad banking that occurred in the heady days of the Credit explosion. I just think this is the wrong punishment at the wrong time. It comes from authorities which played such a big role in bringing on the banking crisis, encouraging excess credit in the years up to 2007, then restricting it sharply. The President has designed a tax which will act as a disincentive to banks to lend more money to people. It is a tax on banks borrowing to lend more. When getting out of recession is the priority, you need to do the opposite. You need to encourage banks to find more money to lend on. This tax might have been a good idea in 2006 to try to limit the excess credit banks were pushing out. Then, of course, banks were more popular with politicians because politicians were some of the worst offenders at encouraging too much lending and borrowing in the private sector. Now politicians like President Obama are acting against too much more lending and borrowing in the private sector, preferring the extra borrowing to be by the state.So why has the President done this? He has done it because bankers are unpopular. He wants to show some backbone against bankers who are about to receive large bonuses again. He wants to deflect any criticism from the Administration for the Credit Crunch and its aftermath. The bankers are an ideal scapegoat.In its own terms it is a misdirected policy. It will not harm the bankers very much, or limit their bonuses this year. It hits bank shareholders more. Bank shareholders include a large number of Mr Obama's own supporters, as they are the ultimate beneficiaries of pension, Trade Union and insurance funds who own shares in the banks. It is a levy that will cut bank profits more than bonuses. If he wants to hit highly paid bankers, he needs to increase income tax. Unfortunately for him that would also hit high incomes that are not earned in banks. It would be closer to what he says he wants to do than this banks tax.Mr Obama's strong rhetoric says this 10 year levy is being imposed so the banks pay back the American people. As many commentators have pointed out, the banks have already paid back the American people with interest for the loans they needed or were forced to take out by the authorities during the crisis. Now apologists are having to say that this extra repayment is to take into account the benefits the banks received from the AIG and motor company bailouts. Surely those bail outs were designed to help Main Street as well as Wall Street? The bankers would argue so were the bank bail outs, but that is another more difficult argument. The irony of the policy is this. The authorities did much to undermine banking profitability in 2007-8. In the last year they have deliberately created an easy money low interest rate regime that will allow banks to make big profits. They did this because they decided that only if banks recovered could they get out of recession and avoid depression. Now this is happening in the USA the authorities are worried about the political reaction to the better profits and the performance bonuses that go with that. This policy will encourage banks to put more things off balance sheet, and to make more profits out of trading instruments and arranging fancy deals. It favours the investment bank at the expense of the High Street bank. Is that what he really wants to do? Look forward to a new set of banking distortions, as they flex to limit the levy. There is some good news. It will bring some money into the US Treasury at a time of large deficits. The modest scale of the levy each year will limit the damage, even though the underlying impact could prove to be the opposite of what government would like to happen. It reminds us that the US banking recapitalisation was handled better than the UK one, where two large banks remain in state ownership and the taxpayers remain on the hook for a large amount of doubtful debts.

Entrepreneurs on strike

12/01/2010 00:00:00

Last week I met a successful entrepreneur who sold the company he had built up some time ago. He told me he was on strike.I knew exactly what he meant. Like many others, he has concluded that there are too many regulations, too many tax complexities, too many difficulties employing people for him to want to put his money back to work in a single company he runs.Of course I was happy to see him, as maybe we can help him with his portfolio of investments. Supervising us running a portfolio of ETFs is much less hassle than hiring and firing staff, complying with health and safety, mastering the latest regulatory requirements on your industry and avoiding the pitfalls of modern employment and environmental law. It might also be more rewarding. You don't need to go into the office every day, you do not have the headache if no-one turns up for work because it's snowing. You are no longer so overwhelmingly responsible as a good boss is in his own business.My new entrepreneurial friend objected to the mood of some in our country. Why do they think, he asked, that we entrepreneurs are always thinking of a mega bonus and pay out? He found that every day he was thinking of meeting his customers needs, of the safety of his employees, of his compliance with all the requirements the authorities impose, and above all with sorting out the crisis of the day which can happen in even the best run businesses. If the mood becomes too anti-enterprise it will put more and more people off having a go, setting up their own business. The rich will live on their portfolio income, and the poor will live on benefits instead. This is one of the reasons we remain negative on the UK. The last few months have seen higher income tax, higher National Insurance, higher motoring taxes and the bank bonus tax. All these measures send the signal that the government thinks enterprise can pay more. They ignore the footloose world we live in, where people can set up their offices and businesses in lower tax jurisdictions if they wish. It ignores the ability of successful entrepreneurs domiciled here to hang up their boots and live off the results of their past labours.If the UK is to get back to its old trend growth rate, let alone make up for the large loss of income and output inflicted by the recession, it will need many more entrepreneurs. At one end of the income scale there are good entrepreneurs on strike. Why should they venture again? Why is government so hostile to them, they ask. At the other end are people with no jobs, who might be willing to give working for themselves a go, who find the rules and controls on benefit payments can make that difficult if not impossible. Meanwhile, the banking controls still militate against a plentiful supply of credit to small business. The regulators are tightening in the midst of a nasty downturn, the opposite of what is needed. Even the government is finding it dearer and dearer to borrow money, despite the quantitative easing. When we recommended selling gilts in January 2009 the yield on a 25 year gilt was just 3.8%. This week it is 4.5%. That means longer gilts have fallen around 11% since then. We think they have further to fall, as we have not yet reached the point where Bank of England purchasing dries up. Nor have we reached the point where the government has a credible plan to curb the deficit.

A world of two halves

08/01/2010 00:00:00

Over the last ten years the Chinese economy has grown by one and half times, and the Indian economy has doubled. In contrast the UK and the US have managed growth of one fifth, whilst the successful exporters, Japan and Germany, languish with only 7.7% growth over the ten years. These figures are changes in total Gross Domestic Product in constant prices measured in their local currency. If you measure them all in dollars of the day you end up with a similar ranking, though all the numbers are much bigger. China has risen by more than 300%, India by almost 200% and the UK and the US have managed to grow by around one half. Germany looks better on this measure than Japan, but Japan is still very poor. Country GDP absolute value % change (Local Currency) Canada 23.2 China 155.5 France 15.7 Germany 7.7 Hong Kong SAR 48.5 India 96.3 Italy 5.4 Japan 7.7 United Kingdom 19.4 United States 20.1Gross domestic product, constant prices National currency Source: International Monetary Fund, World Economic Outlook Database. Country GDP absolute value % change (USD) Canada 99.5 China 339.2 France 80.7 Germany 50.7 Hong Kong SAR 27.9 India 182.8 Italy 73.8 Japan 15.6 United Kingdom 46.3 United States 52.5Gross domestic product, current prices USDSource: International Monetary Fund, World Economic Outlook Database. If we look at the immediate past and the prospects for this year we will see a very similar pattern. China and India keep growing quickly. Meanwhile the US lost 2.5% of its GDP in 2009, the EU 3.9%, Japan 2.7% and the UK 4.6% (Source: Thomson Reuters). A poll of independent forecasters thinks this year will see 2.6% growth in the US, but an anaemic 1% or so in Japan, the EU and the UK. Why should this be? There are three main reasons. The first is, China and India have the advantage that they can catch up with Western technology and productivity levels. Each has a big army of potential employees to come off the land into more productive activities. Living standards are still far lower than Western ones, leaving plenty of scope for growth. The second is because people are still relatively poor and their welfare states badly developed, there is a great incentive for them to work hard or to set up a business and try their luck at commerce. They are hungrier than us. The third is, these are huge countries with very large populations. If India and China are just half as successful as the US in twenty years time, they have will each have economies double the size of the US. What could go wrong with this scenario? Either of these giants could encounter substantial political problems. China might grow tired of communist control and enter a time of troubles as they struggle for power and new constitutional forms. Indian democracy can throw up a series of weak governments and coalitions which fail to control the Indian tiger economy, making mistakes that could harm the growth rate. Both countries might struggle to control the inflations they have unleashed to ensure they grew across the world recession or got out of it quickly. Both currently need tighter money and higher interest rates, but are nervous of the economic and political consequences of doing that. So far markets have been kind to these growing giants, usually rewarding investors prepared to money there in the relatively early stages of their growth. In bad times people have lost more money more quickly, as in 2008, when investors took fright of all risk assets. Many tried to sell their positions in more exotic equity investments. Most who held on have done well, and anyone who bought in 2008 has done very well. Our view is that despite the obvious political and economic policy problems China and India face immediately and in the longer term, these economies are likely to grow a lot faster than the West for the foreseeable future. This does not necessarily translate into higher stock market valuations. That depends on the starting level you buy into the markets, and on the conduct of their domestic monetary policies which will affect asset values. On the bull side of the argument is the astonishing fact that most western investors have missed out on Indian and Chinese growth so far. Many have had no direct exposure to these equity markets. Even the bold investors have typically only managed 5-10% in such Asian equities, whilst holding maybe 50% in US and UK shares which have done so much less well. We expect more western investors to want to have higher exposure to these sources of growth this decade, providing a steady stream of foreign buyers. There will also be plenty of domestic buyers all the time these two countries run relatively loose monetary policies, allowing their home share markets to rise. In the case of China investors need to understand that this is a communist country which licenses limited economic freedoms. The share market level is a matter which the authorities intend to influence, so you need to watch what they do and listen to what they say. On balance we therefore think it still a good idea to have substantial investment positions in emerging markets, with the accent on the two Asian giants. We have been running around 25% of a typical portfolio in emerging markets generally. On the other side of the world and portfolio, we would have less in US and UK shares than the average western portfolio. Both countries have over borrowed. Both are sorting out overextended banking systems. Both have to take action at some point to control their ballooning public deficits. The UK is in the far weaker position, with a larger banking system in trouble relative to the size of the economy, a far larger public sector relative to the size of the economy and a larger quantitative easing programme. The US will benefit from having the world’s main reserve currency. That leads us to avoid all UK government bonds and to prefer shares in other faster growing markets as well.

The trend is not over yet

05/01/2010 00:00:00

Figure 1: 2009 Stock Market Performance Market Index Level (end 2009) % gain 2009 Sri Lanka (Colombo All-share) <.CSE> 3385.55 125.3 Indonesia (JSX) <.JKSE> 2534.36 87 India (Sensex) <.BSESN> 17464.81 81 China (Shanghai Composite) <.SSEC> 3277.14 80 Taiwan (Taiex) <.TWII> 8188.11 78.3 Singapore (FT Straits Times) <.FTSTI> 2897.62 64.5 Thailand (SET) <.SETI> 734.54 63.3 Philippines (PHS Composite) <.PSI> 3052.68 63 Pakistan (Karachi 100) <.KSE> 9386.92 60 Vietnam (Ho Chi Minh) <.VNI> 494.77 56.8 Hong Kong (Hang Seng) <.HSI> 21872.5 52 South Korea (KOSPI) <.KS11> 1682.77 49.7 Malaysia (KLSE Composite) <.KLSE> 1269.89 44.8 Australia (S&P/ASX 200) <.AXJO> 4870.64 30.9 Germany (XETRA Dax) <.GDAXI> 5957.43 23.85 US (S&P 500) <.SPX> 1115.10 23.45 UK (FTSE 100) <.FTSE> 5412.88 22.07 Tokyo (Nikkei average) <.N225> 10546.44 19 New Zealand (NZX 50) <.NZ50> 3230.15 18.9 Source: Thomson Reuters The figures for last year show that all markets performed well after a weak first quarter, leading to some stunning gains over the year as a whole. As we expected, the Asian markets were the stars. They had fallen a bit further in 2008 than the advanced markets, for no good reason. Once people saw the prospects of recovery they rushed to buy shares in Asia ex Japan, Emerging markets, BRICS and other permutations on the developing world theme.We do not think that trend is over yet, despite the very good performance last year. This year there will be more talk of recovery in all parts of the world. Investors will watch to see how much longer the main countries keep up their very loose monetary policies. We have warned before that this year will see increases in interest rates. China and India are already talking of corrective action, as they have lively growth and some inflation. The UK will have an inflationary problem during the first quarter, though it will be reluctant to take urgent action on interest rates given the political timetable and the fear of feeble recovery. It would be surprising if rates were as low by the end of the year as they are at the beginning of it in any major territory.We are not recommending a sudden move into cash, even though there are now risks on the downside and there could be disappointment ahead at the progress of some economies. We think there is still more gain to be anticipated, as most investors will not want to leave large sums of cash earning so little, and will think they should take a bit more risk as the recovery gets into its stride in the emerging countries, and edges forward in the developed countries. We expect the two tier world to continue, with faster growth in the emerging world and slower growth in the West, especially in the heavily indebted countries where both the private and public sectors will have to rein in their appetite for other people's money. We recommend a balanced portfolio, expecting less exciting gains than in 2009. We expect market participants to buy shares and other assets that have seemed to be left behind in the first force of the rally, and to reduce the more extreme risks taken as risk appetite picked up last year. There is some serious fund raising to be done in both the equity and bond markets. There are banks to refinance, properties to fund and there is likely to be more merger activity after the lull of 2008-9.

2010 - Pacific Shift and debt hangover

31/12/2009 00:00:00

Farewell to the noughties. They will not be much mourned. The decade opened in the UK by a relatively fresh government promising us an end to “boom and bust”. We were told we would be run prudently, keeping a watch on the borrowing. The decade ended with the worst boom and bust cycle since the 1930s. It ended with bankers’ reputation in tatters, the UK government’s reputation for prudent finance and good management badly damaged, and the world community demanding more regulation after the worst regulatory failures of my lifetime. The new decade has a poor inheritance. The world economy is likely to be dominated by two main themes. The first is the persistence of the trend to more and more success in the East, as manufacture, services and trade flow to and from Asia. This century will be the Pacific century, just as surely as the last was the Atlantic’s. The second will be the forced efforts of the West to tackle the debt mountains built up in the good years, and added to during the crash. The huge imbalances of the world economy which contributed to the crash have not gone away. In some cases they are becoming worse. The result of the debt overhang should be lower growth for the west and therefore for the world as a whole. There may not be enough demand to sustain the highly aggressive export led growth models of China, Japan and Germany. In any exporters squeeze, brought on by weaker important demand elsewhere, China is likely to be the relative winner. The large debt ridden positions built up by the main western banks, with all the attendant positions in derivatives, options and complex financial products, have also not gone away. There has been some reduction in risk, and large new sums of capital have been pumped in by governments and by the markets. There will be a long and slow workout. The UK is making heavy weather of tackling the big problems of RBS. There are hidden dangers lurking in some continental European banks. There could be more grief from distressed property sectors on both sides of the Atlantic. We think we have seen the best of the asset price recovery. Markets are discounting a useful recovery. Eastern markets, as we expected, have performed better, reflecting the better long term growth prospects. Western markets have moved on from trying to discount Armageddon. For the start of 2010 we remain fully invested, in a balanced portfolio of corporate bonds, growth market equities, property and commodities. We will reduce risks if and when we see world authorities cutting back too quickly on the large amounts of liquidity they have created, and moving too rapidly to the higher interest rates that may be round the corner. If the authorities are successful in 2010 they will end quantitative easing, move to higher rates and allow growth to continue. The risks are on both sides of that careful balance. They could run the QE and low interest rates for too long, triggering another bout of inflation. Or they could strangle monetary growth too soon, and cause a further downwards movement in debt ridden economies. Either way we think the UK is at the risky end of the spectrum, with too much debt and too many difficulties. We advise investors to avoid UK gilts and UK equities. The UK public finances are in a very poor state. The failure of the Pre Budget report to spell out how the deficit will be tamed has started legitimate market worries about how all the debt will be taken up once the Bank of England withdraws from the government bond market.

How were the noughties in the UK?

30/12/2009 00:00:00

We were promised no more boom and bust. We were told the new government elected in 1997 would be kind to manufacturing. It would all be so much better than the Thatcher years.We know the claim of no more Boom and Bust proved to be ill judged. We lurched from super boom to mega bust. What is less well known is just how bad a decade it has been overall, despite the boom. In the noughties the UK economy grew at only 1.7% per annum on average, well below the post war consensus view of a trend rate of growth of 2.5%, and even further below Mr Brown's estimate that he had raised the trend rate of growth to 2.75%. The UK economy grew more slowly overall during the noughties than it had in either the eighties or the nineties. Manufacturing fared particularly badly. In the 1980s manufacturing output expanded at 1% per annum on average across the whole decade. In the noughties it contracted at an average rate of 1.2% per annum. In other words manufacturing did better by around one quarter in the 1980s than it did in the noughties. This is the opposite of the conventional view, which believes manufacturing was particularly hard hit by the events of the 1980s. After a sharp contraction at the beginning of that decade manufacturing expanded, producing overall growth for the ten years. In the noughties poor performance at the beginning and a very large decline at the end left manufacturing in retreat for the ten year period. The present government has also failed to help the north and west relative to London and the south east. I am sure they wanted to balance things up, and get the north and west growing faster to catch up with living standards in London and the south. Instead the gap between London and the rest grew ever wider during the last decade. In the 1990s London grew at 2.9% each year on average, compared to 2.2% for the UK as a whole, so London pulled further ahead. In the noughties London grew at 2.7%, whilst the UK average fell to just 1.7%. In other words, over the last ten years, London has seen an improvement of more than one tenth in its living standards that the rest of the country has not enjoyed, despite starting from a much higher average income level. The UK faces trouble ahead. The growth figures of the expiring decade, poor as they are, are still flattered by the artificial bubble based on borrowing too much in both the private and public sectors. Everyone, including the government, now accepts that the levels of debt have to be brought down. As the UK deflates demand by repaying borrowings, so we should expect a lower rate of growth. I have been forecasting a fall in the trend rate of growth from the Treasury's 2.75% and the post war average of around 2.5%, to something under 2%, maybe to 1.5%. That now looks optimistic. We will be doing well if in the decade ahead we grow at 1.5%, slightly below the 1.7% achieved in the noughties with the benefit of all that extra borrowing and artificially created money. The UK economy needs a dose of realism. It needs to curb public borrowing by controlling public spending. It needs to boost the productivity of the public sector substantially, so it does more with less. It needs to offer a more competitive tax and regulation package to business, so it is better made in the UK. We need to work harder and export more as a nation. We need to start earning our way in the world. There is some welcome evidence that after the falls in sterling some manufacturing orders are returning to the UK from overseas. A better balanced economy will need more of this. This Christmas and New Year may see the end of the fairy tale. It is still possible to go into the shops and buy great products at low prices, made by the ingenuity and hard work of many Asians, especially the Chinese. Much of this buying has been on borrowed money, now largely borrowed through the public sector, and passed on in public sector wages, benefits and direct public sector purchases. If the UK does not get a grip on its financial affairs the markets will take further fright. Despite the money printing, the cost of government borrowing has been rising in recent weeks. If government does not take control and start to sort it out, the markets could drive interest rates higher still, doing damage to any recovery and forcing change upon a reluctant government. The government is wrong to think we need to keep spending and printing to have a recovery. Now the biggest enemy of sustained recovery and well balanced growth is overspending by government itself. We continue to advise against buying or owning UK gilts. Yields have been rising and prices falling despite the continuation of relatively easy money. There could be more painful adjustment ahead. Meanwhile the last decade has seen no return from buying and holding UK shares. Since entering the market after the crash we have preferred overseas equities in faster growing economies. These have performed better overall as we hoped.

That was the year that was

29/12/2009 00:00:00

That was the year that was. Life returned to share markets around the world. The rising stars shone most brightly, but even the old markets of the West showed a lively turn of pace from the March 9th lows. More liquidity works wonders.Now we can look back, we must ask why did the authorities so starve banks and markets of cash in 2008, and why did it take until the early months of this year to cut interest rates and create enough cash to start to mend things? It made 2009 a game of two parts. The first ten weeks was a savage bear market, the rest was easy money.We started investing the cash before the market turn, and moved to being pretty fully invested in the second quarter. Later in the year we added property REITs and commodity index investments to our share and bond positions whilst taking some profits on US shares. Asian property did well in the second half, and commodities finished very strongly. It was not difficult to make people money in 2009, as the cash created by the Fed, the Bank of England and others moved swiftly into shares, bonds and commodities. China helped by making major expansionary injection of funds into its economy, and by stockpiling raw materials at the lower prices. Next year interest rates will rise. The Fed and the Bank of England are briefing that they intend to keep their indicative rates low for a long time. However, the government bond markets may think otherwise and move longer term interest rates up. In the UK the private sector already expects a considerably higher rate than 0.5% for savings, and banks are extracting many times the bank rate when lending. The argument will be over the borrowing rate for the government itself, which has been kept artificially low on both sides of the Atlantic by quantitative easing, which is now coming to an end.Against this background it will be necessary to be more selective about which markets and asset classes to stay with or to invest in. We doubt if we will repeat anything like the returns of 2009 in the main share markets. We will go into 2010 with lower share exposure than we were running during the best of the markets in 2009.

Happy Christmas to you all

25/12/2009 00:00:00

Today there are better things to do than to write at length on the state of world markets. I wish all my readers a very happy Christmas, and a great New Year. I hope this column helps make your lives a little more prosperous, by keeping you out of some of the worst troublespots. Today markets are closed so worry not and open a good bottle of something you like.

Tilting at windmills or investing in them?

22/12/2009 00:00:00

Ardent enthusiasts for a global attack on CO2 output will be disappointed by the outcome of Copenhagen. There was no new set of Kyoto targets, no strong review mechanism, no agreed global standard for reporting results, no sanctions for countries failing to make their contribution. Optimistic greens say that nonetheless the USA, India and China are now in the process, and that following the summit there will be individual country targets registered with the UN. Pessimists say the clock is ticking faster than global political agreements can be reached.We are not surprised by the results of Copenhagen. The truth is it was never likely that the all the world, including the USA, China and India, would sign up to very tough targets to cut CO2, and go away happily sharing data and accepting international pressure to hit them. China and India take the view that they need to grow quickly. That will entail more CO2 output, just as it did for the rich countries of the world in their comparable growth phase. The US President may be willing, but he knows there are tight political constraints on what he can sell to a worried and sceptical Congress. Australia has just had a political warning about the limits to acceptability of global warming inspired policies, with the change of Opposition leadership in protest at carbon trading plans.We do not think it has many investment implications. It shows the world leaderships are mainly preoccupied by getting growth going again in the west, and rebuilding super growth in the east. We explained recently why we did not buy into the Clean Energy ETF as our Copenhagen stock of the year. The outcome of the conference makes us doubly glad we took that view. The future of markets for the time being is going to be determined by what these leaders do on monetary and debt policy, not by their attitudes towards the climate.

Here are the results of the Copenhagen jury...

18/12/2009 00:00:00

At Evercore Pan we have always liked the green themes for business. A couple of our largest clients have been most successful in seeing the opportunities the drive for greater fuel efficiency and new ways of generating power present to engineering businesses. We have as one of our central tenets about the way the world is going the likelihood that more and more resource will be devoted to alternative energy, to fuel efficiency and to new ways of powering vehicles and heating buildings. There is an ETF way of investing in this theme. You can buy an ETF which gives you exposure to a global portfolio of clean energy company shares. Despite our belief in the theme, we have not yet bought any of these for our clients. In 2008 we ruled out this ETF because we were negative about all share markets, and did not see how clean energy shares could buck such a savage trend. In 2009 we had longer internal debates about it. Some colleagues thought clean energy would come to the party in 2009. They could argue that these shares would recover with world markets. A new President in the USA was committed to joining the world consensus on the need to tackle rising carbon dioxide emission levels. There would be a new world conference which in turn was likely to ratchet up the requirements for alternative energy and fuel savings. We still did not buy them. Our concern about levels and growth rates of income made us cautious, as the yield is low on these types of investment. Other markets and assets seemed to offer better returns. Whilst there is plenty of talk about the green prospects, turning them into hard cash and profit is proving time consuming and sometimes difficult. The election of a "greener" President may make a difference, but the US Congress and Senate, and the US people, are still reluctant to put their full weight behind CO2 reduction if it means sacrifice or higher costs and taxes. We decided to wait and see. That proved to be a wise call in 2009, as the clean energy ETF has produced a return of -7% compared to a return of 42% from a Far East (ex Japan) equity ETF for the year to date. Will Copenhagen make a difference? Not a lot. Assuming they do reach some agreement on new C02 reduction targets and on money transfers from rich to poor, it does not change the politics of the USA nor the yields, dividend growth rates and business challenges of the companies. It may change sentiment, depending on how strong the text is. We will keep you posted on that. The truth of the position is that whatever comes out of Copenhagen, green politics have taken a bit of a knock in recent weeks. The leaked emails from the University of East Anglia on climate science have strengthened the hand of sceptics to the point where the media will now put an alternative case. In Australia the Leader of the Opposition lost his job by being too enthusiastic about the policy consequences of global warming theory. In the USA the President has shown that he intends to spend most of his political capital on health care, and some on the war in Afghanistan. He will not have a lot left over to battle the Congress and arm wrestle the Senate on climate change. Wise companies will continue to build recycling, fuel efficiency and green products into their approach. There is money to be made from it. We are still not ready today to buy the clean energy ETFs, but we will have another look when we know more about Copenhagen's outcome. Clean energy ETFs and funds buy shares in companies specialising in clean energy production or the manufacture of equipment and technology for the clean energy industry. For example, this includes hydroelectric and thermal power plants, generating energy from waste, solar energy and photovoltaic cells, wind turbines, tidal power and heat recycling. Over half of the geographic exposure of the S&P Global Clean Energy Index is to the US, China and Germany.

Keeping it simple - beware rising UK interest rates

15/12/2009 00:00:00

Our motto is Keep it Simple.In 2008 we thought the banking crisis and monetary squeeze looked bad, so we stayed in cash or moved into cash for our discretionary clients. We reasoned if we were wrong they would still make 5% on their money, and if we were right they would save themselves a nasty fall.This year we have been invested in shares and corporate bonds. The returns on cash were poor, and it seemed likely the authorities were going to print and create money to try to instigate a recovery.The most obvious thing to say about the year ahead is that UK government bonds still look dear, even after the sell off last week. We have said to our clients, avoid them. When did people last get rich by lending to the UK government at 2-3%?What do you think is going to happen when they stop printing more money to buy their own bonds? Do you think at some point the Bank of England will want to start selling all those bonds it has bought up? What happens to the price of bonds if the government has to issue more to replace the ones the Bank has bought? What interest rate will the government need to offer to sell another £200 billion of gilts without the Bank as a buyer?Before last week’s sell off most of the UK government bonds were trading above their repayment price, so you knew if you held them to repayment you would lose money. You were relying for your return on the fixed income they pay and the opportunities to reinvest that income. If we are right about government bonds we will spare you some guaranteed losses if you hold to redemption, and some larger losses if you need to sell in the market and the government bonds do fall in price as we fear.If we are wrong, and the government holds the confidence of investors, it is difficult to see you making much money on them. Meanwhile other assets in such circumstances are likely to make you more.Keeping it simple meant staying in cash during the crisis. Today it means staying out of gilts or selling any you have left. I would hurry whilst the government is still a buyer. In the past when UK governments have had to borrow a lot, gilts have fallen and interest rates have risen. Why should today be any different?

Weak budget policy will drive up interest rates

11/12/2009 00:00:00

It just had to happen. On Wednesday afternoon after the UK Chancellor’s Pre Budget Statement, the UK government bond market started to tumble. The following day, the falls became serious.We have warned clients not to be trust in gilts for several months. We have sold all gilt holdings from discretionary portfolios. The arithmetic of the UK public finances never made any sense. The banking risk that the state is running is too great. Once quantitative easing comes to an end it is likely interest rates will rise and prices fall.The declines set in before the ending of QE because the markets can now see for themselves there is no credible plan to reduce the UK deficit. The Pre Budget Report, far from tackling the problem, increased spending, taxes and borrowing. Markets wanted spending and borrowing to fall, and did not want to see more taxes on enterprise, saving and investing. Many market participants want the UK to attract and grow more business to earn more revenue. The PBR documents revealed a further increase in the forecast borrowing for 2009-10 and 2010-11. The government proposed a generous increase in pensions in the circumstances, and further increases in benefits and free school meals. It is introducing another 0.5% increase in the payroll tax, National Insurance, and a one off bonus tax on financial businesses. School, hospital and police budgets will be ring fenced to avoid cuts, making the need for reductions elsewhere that much larger. The Treasury remains wedded to its idea of halving the deficit over the following four years. This Statement moved more of the reduction to the second half of that period, and failed to explain where the individual spending cuts and further tax increases would come.The markets had wrongly hoped for something clearer and better thought out. They were prepared to accept the government idea that the cuts should not begin before recovery is underway, but they did expect a sharper definition of recovery and the cuts that would then be needed. It is anyway an arguable point that you have to avoid spending cuts before a recovery commences. In 1981 spending cuts and loose money policy powered the recovery. In the early 1990s earlier action was taken to curb a lower deficit, but this did not prevent recovery.In the week that Greece suffered its second downgrade to BBB+ status for its bonds, and the week in which Ireland took the axe to public spending in a dramatic way, the UK package was never likely to impress many in the markets. Gilts have fallen. Interest rates for the government have risen. I fear there is more to come along the same lines, unless the government has second thoughts and does set out a credible path for the earlier reduction of the deficit.The government’s bond salesmen were out in force saying that the ending of QE did not mean the end of low interest rates. The Bank of England is currently wishing to keep short-term rates down for longer. The commercial banks have to start buying more government bonds to meet the new liquidity requirements, just as the Bank of England throttles back on it purchases. All this was not enough to win people over. Selling another £200 billion on top of this year’s generous supply remains a tall order. Confidence is a precious flower. It is not easily cultivated, but it is easily crushed.

The US and the UK are up the same creek - but the US has a paddle

08/12/2009 00:00:00

We are on the eve of the US President's economic speech, and the UK Chancellor's Pre Budget Report. They will be somewhat different statements.The authorities in both countries made bad mistakes with monetary policy between 2004 and 2008, first pumping it up too much, then imploding credit too quickly. Both countries ran up large public deficits in the good times, then increased the deficits dramatically in the bad times. Both offered large amounts of support to overextended banks. Both have governments with a love of public spending regardless of the state of the finances. Both have been running large balance of payments deficits. The Statements are likely to reveal, however, that the UK is in a worse position than the US. The US downturn was shallower and ended earlier, limiting the financial damage. The US economy has narrowed its large trade deficit more, the UK less, despite both following weak currency policies. The US banks in trouble were smaller relative to the size of the government and the economy than the UK ones. The US banks have made swifter progress in sorting themselves out and repaying the public assistance than RBS or Lloyds in the UK. As a result the President has the pleasant task of reporting large sums of cash returned by the banks. He could use this to cut the amount of debt he needs to raise and service, or he can spend more on employment generating programmes. He will probably do a bit of both. A sustained recovery does require action to curb the deficit, so the more he can use to cut borrowing the better. The US has two other great advantages compared to the UK. It has the world's reserve currency, which many will need to hold regardless. Sterling enjoys no such comfort. The US owes so much to large creditors like China that there has to be give and take on both sides as they size up the US borrowing needs in the months ahead and the Chinese investing needs. Sterling government debt is not in the same league, so it can be treated differently by the big creditor nations. The UK still has to come off quantitative easing. When it does so foreign buyers of government debt are likely to want a higher interest rate for their trouble. The UK Chancellor should set out just how he intends to halve the UK deficit over the next four years. He has promised to do this through his Deficit Reduction Bill, but has so far given little detail. The current deficit is running at over £180 billion. This means spending cuts or tax increases to the tune of £90 billion to halve the deficit. The deficit by the end of the four years would then be at the high level that triggered the IMF crisis for the UK in the 1970s, so the target reduction is in one way not very demanding. In other ways it is a big task, requiring far larger cuts and tax increases than any previous exercise since the Second World War. We should expect some pre-election smoke and mirrors rather than comprehensive spending reductions that can cure the structural deficit. The Treasury may well argue that some of the £90 billion will come from the growth of the economy, gradually cutting the cyclical part of the deficit. It is difficult to believe the cyclical element is as much as half the total, and the cyclical recovery surely is needed to cure the half of the deficit the government does not propose to cut. The deficit reduction should concentrate on the structural deficit, the part that comes from inefficient or less desirable spending. There will be spending cuts outlined. Most of these are likely to revolve around the new found enthusiasm for efficiency gains. We move into a world of Gershon plus, finding new ways of curbing costs. There may be more cuts along the lines of the announcement of an end to the central computer procurement in the NHS.At the time of the Budget the government's forecast of £175 billion of deficit this year (excluding banks) was said to be an overestimate, reflecting deliberate caution by the Treasury. The briefers briefed that the outturn would be lower, and loyal commentators duly obliged by writing that the government had at last got on top of its growing deficit and was now taking no risks with its forecast of an unpleasant surprise. Ahead of the PBR the briefing now goes that the government will only overrun its forecast by a little bit. The deficit we are assured will not hit the £200 billion estimated by some private sector pundits. We should beware of briefing from the usual sources this close to an election. We need to study the small print carefully. The UK finances are in a dreadful state. The longer they delay tackling them, the worse it will be when they do. We continue to advise against owning UK gilts. Interest rate rises on UK government debt are likely over the next year. The UK economy is declining relatively, falling to lower places in the tables of economic size and competitiveness.

Sell gilts while the Bank is still buying

04/12/2009 00:00:00

The UK National Audit Office yesterday confirmed that taxpayers have £850 billion at risk through government guarantees, subsidies, shareholdings and other support for the banks. This is a generous way of working out the figures. In practise taxpayers are on risk for £3 trillion of banking liabilities at Lloyds and RBS, as we all know it will be taxpayers who pay their losses if they make more. If we equity accounted for these two banks as private sector companies do, attributing some of the risk to the other shareholders, it is still a £2 trillion plus taxpayer commitment. On the NAO's figures public debt and financial risk is double the old figure, thanks to the banks. It now exceeds National Income on their figures. The NAO also revealed that the cash cost of the banks so far to taxpayers is £117 billion plus refundable fees, producing a gross total of £131 billion. That is larger than either the Health or the Education annual budgets. Readers know that I recommended a far cheaper and less risky way of seeing the bad banks through the crisis. Now we are where we are, there are still cheaper and better options for taxpayers from here.The overriding priority should be to cut the risk to taxpayers. Selling off foreign banks from within the RBS and Lloyds group would allow taxpayers to get cash back from their forced investments, and would reduce the risk of future losses. Winding up or selling on much of the investment banking business would also cut the risks. It would have the happy political effect of removing the highest paid executives with their bonus pools from the taxpayer. It would mean that next time a Dubai World stops making payments it will just be private shareholders and their bank executives who have to sort it out, not the hapless UK taxpayer and the state bank executives. It is unlikely the government will do this. Their strategy seems to be based on carrying out the modest disposals required by EU competition law, and then waiting until they can sell shares in the banking Groups at a better price. As a result the UK state will continue to be very stretched not just by its running deficit and accumulating public debt, but also by the large additions to its financial risk from its ownership of two large banking groups.This week the Bank of England announced that it might in the future sell some of the corporate bonds it has bought as part of its Quantitative Easing programme. As it has only bought around £2billion of corporate bonds compared to a planned £198 billion of gilts, it is a small sum. It is interesting, however, that it might wish to do this. The Bank added that it would buy additional gilts with any money it raised from the sales.The Bank is not saying it wishes to start to reverse its QE programme. It is saying it thinks selling corporate bonds on yields in excess of 6% to buy gilts on yields between 1% and 4% is a good idea. It is difficult to see why. Most portfolio investors are going the other way, apprehensive about what happens to gilt yields when the Bank’s own massive buying programme ceases. It looks as if the Corporate Bond policy is another attempt to have enough fire power to keep gilt prices up for a bit longer. The given reason was the Bank wished to assist liquidity in the corporate bond market. These developments reinforce our view that investors should sell gilts to the Bank whilst they are still buying.

Charity Gala Concert

02/12/2009 00:00:00

Our clients and friends may like to know that we have helped Pancreatic Cancer Charity raise more than £34,000 from the concert. We thank James Brown for all his hard work in organising the concert, and all those who came and supported the cause. Matthew Trusler enchanted the audience with his violin performance of the ‘Lark Ascending’. The singers Natasha Jouhl, Madeleine Shaw, Ben Alden and David Kimberg added their magic to the great playing of the English Chamber Orchestra. We had a good night out, made all the better by the Evercore champagne reception.

Can you trust Sovereigns?

01/12/2009 00:00:00

On Thursday Dubai announced problems with meeting payments on loans for its extensive property development programme. Some investors had thought these bonds were Sovereign risk backed by the Dubai Government. In turn they expected the UUAE Government to stand behind its adventurous member state. They were wrong. The governments walked away from the debts. Markets fell sharply around the world as fear temporarily took over from greed. It did not help that Dubai was closed for a religious festival and little information came out about the nature of the financial problem. Was it a temporary cash flow difficulty? Was it just a wish to reschedule payments? Or was it bankruptcy? World markets fell on the precautionary principal, incase losses were large, and incase they shook the foundations of weak banks and other counterparties. This week markets have shrugged their shoulders and recovered. Word on the street is the losses will not be too large. The UUAE and Dubai governments will not stand behind the property loans, but they are making money available to local banks to prevent a run or further collapse. No one main Western bank is thought to be badly exposed. The property company borrower is in talks about restructuring the debts and selling assets, so not all the money is lost. It was a timely reminder of two things. There is still a lot of bad debt out there, much of it secured on property which has lost value. Sovereign debt is not always the safe option. Some debts thought to have a government guarantee do not enjoy one. Some Sovereigns may also be bad debts. We put some money into markets at the end of last week in the panic. We have always been suspicious of over-borrowed states as well as over borrowed banks. Last week’s wobble reinforced our views that investors would be wary of countries too much in debt and should remember the great debt overhang has not gone away. This was a big financial crisis, and there will be aftershocks. There will also be slower growth in the over-borrowed places as they pay off debt and raise taxes.

Sovereign Risk

27/11/2009 00:00:00

Yesterday markets convulsed as news came out that Dubai was unable to meet the payments on its large property debt. At a previous time of stress Abu Dhabi had come to its aid. This time there are limits to how much support there will be for companies owned by the Dubai government. It is a timely reminder of two things. The first is that the banking crisis is not yet worked through or fully resolved. It is likely that RBS, for example, has lent money in Dubai and will have to reassess the value of its loans. The second is that governments and government backed entities are not always AAA rated or entirely reliable credits. Traditionally leading governments meet their interest and capital repayment schedules, but often reduce the costs by encouraging or allowing inflation to erode the sums involved. Lesser governments may default on payments or walk away from government sponsored entities that investors thought had an implicit government guarantee. This is a time to consider sovereign risk more seriously. Many governments have been borrowing too much. Many governments were caught up in the euphoria of off balance sheet financing prior to the Credit Crunch, helping the innovators in the financial markets. Governments themselves liked being able to do more and buy more without apparently swelling their own debt ridden balance sheets by as much as the total borrowing. In these tougher times all those off balance sheet and government owned company debts fall due or need servicing as well, out of more restricted tax revenues following the slump in activity. We have cut risks in portfolios in recent weeks. We recommend continuing to avoid UK and US government debt, where prices are distorted by both quantitative easing and year end balance sheet window dressing by banks and others. One of the losers from the Dubai experience will be the British government, as owner of two large banks. The banking crisis may be over its most severe phase, and governments are likely to continue to stand behind the big banks. There is however still plenty of scope for further losses, as this mini crisis reminds us.

Increased political risk in UK markets as polls narrow

24/11/2009 00:00:00

The UK economy will be run on full throttle up to the election. Public spending will be high, money will be loose, interest rates will be kept down. The government will “do what it takes”.Some of the numbers will improve. We expect the UK economy to start showing signs of recovery, on the back of the earlier and stronger recovery visible in Asia, the Americas and even on the continent.Some of the numbers will deteriorate. We have sent the first instalment of the inflation rate rise. The Bank of England itself thinks the rate will rise to 2.7% in the first quarter of 2010, with some commentators thinking it might rise even higher. The deficit and accumulated debt figures will also look poor, as last month’s did to the surprise of many analysts. The Bank of England will want to keep interest rates near zero until the likely date of the Election on May 6th. They will continue with quantitative easing at a slower pace than at the peak of the programme. They will accept any devaluation of the currency that might occur, and will argue that inflation will come back down again in due course.The markets have been assuming a Conservative election victory to be followed by tougher action to curb the deficit. The latest Mori poll shows a narrower Conservative lead of only 6%, which if delivered in the ballot box would produce a hung Parliament. The main change in the last two months in the Mori figures is a decline in the Lib Dem vote, and a rise in Labour vote. This one poll may not be confirmed by others. Conservative support may rise again. It is, however, a timely reminder of the political risk in the UK alongside the economic and financial risk. There could be an indecisive result in Parliament, which could usher in a period of delaying the major decisions whilst the parties jostle for an opportunity to go for another election. In 1974 a hung Parliament in the February election led to a period of political positioning and continued spending until the minority Labour government in the autumn felt confident enough to call another election.We are still concerned about the wide range of risks in the UK. The banking sector is still damaged, and very large relative to the size of the economy. The public deficit is too big and growing too quickly. Money is now flowing into the property sector in Asia and closer at home into high quality well let investments. These are especially attractive to foreigners buying into devalued pounds. We think REIT (Real Estate Investment Trust) ETFs offer reasonable value at current levels, with a yield advantage over general shares.

Complex funds can bring complex risks - we avoid them

20/11/2009 00:00:00

There are rows brewing in the world of Exchange Traded Funds. Some providers are creating complex ETFs, new types of fund which offer kinds of active management or offer to gear or short underlying assets. At Evercore Pan-Asset we do not use of any of these. They do not pass our tests of simplicity and low costs.We are asset allocators. Knowing that getting the choice of asset class right is the main determinant of your returns, we then try to implement our chosen strategy as cheaply and simply as possible, in a way which reduces risks. We are not wedded to ETFs. The simple ones just happen to be the cheapest and best way of investing in asset categories with Stock Exchange liquidity and transparency. If something better comes along we will buy it. We looked at the ETFs that short markets when they came out. It was easy to reject those. When we think markets are in difficult times we do move into cash for clients. If we are wrong clients still make a return on their money. If we are right we protect them from declines in share, bond and property markets as well. If you increase the size of the bet by shorting a market, you can lose serious money if you are wrong. We do not think that is the right approach for long-term trust funds, or for wealthy individuals who wish to look after their money prudently.We looked at the geared ETFs, funds which offer you twice or three times the upside on a market when it is rising. The bad news is you also double or treble your losses if the market goes in the other direction. These ETFs cannot guarantee to deliver the double or treble performance owing to the technical way they are structured. It was again an easy decision to say we would not be buying those. It would be best if these complex ETFs were called something other than ETF. Exchange Traded Notes are also different in their structures, relying much more on derivatives, contracts for difference, options and the like. We never buy them, as they too contain different types of risk than a simple ETF based on a portfolio of shares. We saw what pressures can build up in the world of synthetic products and complex instruments during the crash of 2008. We were happy sitting in cash. The more complex ETFs there are, the more important it will be to do some homework before buying one. You need to examine the underlying assets, any contracts for differences, and other financial instruments. You need to consider counterparty risk as well as market risk in the complex cases.

Taking an alternative approach

17/11/2009 00:00:00

The last decade has been a very poor time for all those funds which bought and held US, UK and European equities. Funds have lost money over a whole ten year period. The old theory that all you had to do for a charitable fund or long term pension fund was to buy and hold equities has taken a knock.The position in Japan has been even worse. The market today is around one quarter of the level it reached in 1990. It has never been back anywhere near the 1990 high for two decades. In recent years many funds were persuaded to buy into a range of alternative investments. These were actively marketed and offered apparently much higher returns than conventional share portfolios. Larger funds invested in commodities, in property, in hedge funds and in private equity. These asset classes were said to move differently from stocks and shares, so they apparently offered diversification. If shares fell, the theory went, your portfolio might still benefit from the alternatives.In 2008 commodity prices fell, property prices fell and private equity entered a very tough time. Most alternatives were damaged by the very same things that hit equities. If credit dries up and people become risk averse, private equity, property and commodities will suffer just as surely as snare. Many hedge funds also went down. They too depended on borrowing, and needed some markets to be rising. Only the funds which specialised in shorting shares or a few other exoteric strategies avoided the downturn.During the dislocation many funds discovered that their holdings in private equity and property were very illiquid. If you owned these assets directly, you were locked in as there was little secondary market for private equity company shares or for second hand properties. If you owned them indirectly through funds you were also illiquid. Many of the funds both cut the stated asset values rapidly in response to the collapse, and made it difficult or impossible for investors to obtain an early exit from their holdings. Funds experienced the illiquidity, but did not benefit from superior returns to pay for that extra risk and inconvenience. Even some of the commodity funds were difficult to get out of. They suffered badly from the price collapse. Looking at the modern investment universe, we do not think 2008 proves it is wrong to invest in property or commodities or private equity. Each is different. There is a lot to be said for a stream of income from rent which is a prior charge on company income, which in normal conditions rises. It is likely as 2.5 billion Chinese and Indian people grow richer that there will be strong demand for more commodities on a scale not seen before. Private equity can be a good way to improve company performance, and it should be possible to benefit from turbo-charged corporate performance which comes from the incentives and short lines of command in those companies.However, we think there were also warnings in the 2008 experience. It does lead you to ask if you want to be locked up in assets you cannot sell at a decent price if things turn bad or if you change your mind. The fee structure on many alternative products is generous to the managers at the expense of the investor. That is why we favour investing in alternative assets through vehicles which are much more liquid.There is now a range of ETFs which can take care of the need to invest in a wider range of asset classes, but in a way which is as liquid as the share market. The ETFs in property buy portfolios of quoted Real Estate Investment Trusts, offering a better yield than the average share yield in the comparable market place. The ETFs for commodities keep most of their money in low risk short dated instruments, with the commodity exposure limited to options to ensure the fund matches the commodity index. The private equity ETFs buy into the quoted shares of the main private equity companies, which in turn own shares and incentive packages in their target companies. An ETF shareholding can be bought or sold in a minute using the normal share exchange. If liquidity in that particular ETF is limited on a particular day, the manger of the ETF will buy or sell the shares, creating or destroying units, by buying or selling the underlying shares in the fund. Evercore Pan-Asset would be happy to design and run a portfolio of suitable alternatives for larger funds. We could offer something that should be more liquid and lower cost than direct or specialised active fund investment, and something which is more liquid. The aim is to match the relevant property or commodity or private equity index. We would be happy to discuss this with you or send you a proposal. Now we have had a good rally in share markets, it is a good time to be thinking about this type of diversification. None of it will be Credit Crunch proof, but it can give you a better and rising income and scope to beat the share blues which we have experienced over the last decade in advanced markets.

Foretelling the Future

13/11/2009 00:00:00

On Tuesday I have agreed to talk to a brain storming session on what might happen next to the UK and global economies. I am now planning my talk. The ideas appear to be based on scenario planning. We all accept that single forecasts of the future are prone to error. Instead we set out a range of possible outcomes, and then try to ascribe a probability to each. Here are four that I am thinking through, reflecting different investor perceptions in today's markets.Scenario One: “We all live happily ever after”. This is the best case for the authorities. In it the US and the UK are miraculously transformed into nations of savers and exporters, whilst the Chinese, Germans and Japanese develop a passion for consuming and importing. The US and UK withdraw their monetary stimulus in perfect time, leaving quantitative easing behind them and then putting up interest rates sufficiently to prevent inflation but not so high that they choke off recovery. The benign forces of globalisation and digital technology resume their reign. The world grows again in a sustainable way. This could be an extreme version of a normal boom/bust/boom cycle.Scenario Two: “One bubble more”. As investors pile into gold and index linked securities, this is a popular view. In it the monetary excess evident today in China and India as well as in the US and UK spills over from asset prices and commodities into shop prices and wages. We have another flurry of fun, before the whole edifice comes crashing down again when the authorities lurch back to tight money and tougher attitudes to debt and spending. The problem with this view is the broken western banks currently are not able to pass on the high powered money to private sector lenders. Private sector wages are under tight control on both sides of the Atlantic. The probability of this happening soon seems low. Scenario Three: “The US and the UK are the new Japans”. There are still gloomsters about arguing that we are in for a long period of deflation. After 1990 Japan had an industry of broken banks. It took them years to sort them out. The government attempted money printing and huge fiscal deficits, but nothing made much difference to no growth or low growth. No amount of quantitative easing could lift the price level. Persistent zero interest rates failed to solve the banking and credit crunch. Could the US and the UK find the same happened to them? After all they have had a similar over extended property boom, a similar collapse in banking credit, and are now following similar monetary policies? I suspect not. The Anglo Saxons do not have the same ageing population and the same drive to save as the Japanese. The US and UK are better at inflation than Japan, and both countries have a vested interest in devaluation, to inflate away some of the debt burden.Scenario Four: “Markets force adjustments”. The remorseless rise of Asia, led by China continues. The Anglo Saxon economies find there are limits to how much they print and borrow. They enter a period of painful adjustment, with higher interest rates than they would like as they seek to sell their debt. They grow more slowly than their old trends, and are forced to divert more money from private and public spending into exporting and debt service. The world grows, but at a slower pace than prior to 2007. There are occasional country crises, marked by currency and or banking collapses. The shift of power and profit to Asia continues apace. Number four seems the most likely to us, but exponents of other views are shifting the gold price.

Ethical investing revisited- the complications

10/11/2009 00:00:00

From time to time potential clients ask me about ethical investing.I often share their concerns. I do not want my money to be used to further wars or criminal activity. A common request is can we avoid investing in armaments?Some think that placing a ban on buying shares in the leading weapons manufacturers makes the point. The problem with this is the main arms companies depend on a host of other businesses, outsourcing many of their activities, and relying on the services of many others. If we ban buying British Aerospace as an arms maker, what attitude should we take to the bank that provides them with their working capital, to the advertising and PR agency that handles their account, to the component maker that supplies them with their crucial parts or to the computer supplier that provides them with the hardware and software that enables them to design their weapons?Should we seek a distinction between "ethical" arms makers who sell weapons for defensive purposes to countries we approve of, and those manufacturers who sell potentially offensive weapons to belligerent tyrannies? Are we happy with the sale of weapons to countries fighting wars under the imprimatur of the UN or not? If you wish to be sure you are not supporting state inspired killing, you need to cast your net very wide when avoiding investments in companies that profit from this trade.I think worse still is to lend the money to the governments that buy and use the weapons. How could you justify holding US or UK government bonds if you objected strongly to the Iraq war? The bonds directly financed the conduct of the war and the purchase of the munitions and weapons.Similar complexities arise with medical issues. Some say they do not invest in tobacco shares because smoking can be so harmful to health. What attitude should we take to pharmaceutical shares? Many see these as entirely benign, trying to save lives. Others argue that testing on animals is unacceptable practise still undertaken by some companies, whilst excessive drug taking can itself be damaging to health.As an investment manager I am here to serve my clients. My individual dislike of animal cruelty and aggressive governments does not colour my investment judgements for others. If a client wishes to express a particular ethical view, we will implement it or explain why it is difficult to do. Using index trackers allows you to avoid lending to governments that are unpleasant and countries that behave badly. It is also possible to compile indices leaving out types of company or shares if that is required. ETF providers are happy to look at any suggestion for a new index if there is demand for it. We would be happy to discuss this with charities that have particular ethical needs.

Further stimulus prolongs opportunity to exit Gilts

06/11/2009 00:00:00

This week has seen better signs of recovery in the US, modest recovery in UK industrial output in the latest figures, and clear indications from the UK authorities that they are not rushing to end special measures. The world is still awash with easy money, low interest rates and excess savings. As a result asset prices have risen sharply from their lows, there is plenty of speculative interest in commodities, and the Asian economies are making good progress. We remain concerned about the state of the UK banks and the public finances. This week saw the announcement of another £25 billion of quantitative easing from the Bank of England. Their approach seems to be to reduce the rate of money printing gradually. That means adding more to the substantial stock of government debt the Bank owns. It will allow another three months of government borrowing at artificially low rates. Anyone with gilts should take this continued opportunity to sell, in order to reinvest in better value instruments. In addition the government announced over £30 billion of new capital for RBS and its share of the Lloyds rights issue, along with provision to convert another £8 billion of RBS obligations into share capital should need arise. This underlines how the first large packages did not prove to be sufficient, and reminds us of the weak position of RBS. RBS is a bank with assets and liabilities larger than the National Income. All the time it remains on the government's balance sheet it is a risk to the public finances. They are taking a very long time to do the necessary work of deciding what needs to be written off, what can be worked through, and which businesses should be sold on to new owners.Insufficient progress has been made in tackling the large imbalances in the world economy between the borrower economies and the savers, between the importers and the exporters. The ending of special measures to boost car demand may see some relapse in auto manufacturing next year. The German economy is carrying a lot of surplus labour, kept off the unemployment registers by government schemes. The US economy still has a substantial real estate overhang, and poor consumer sentiment after the shocks of the Credit Crunch. The UK still has its main adjustment to come, as it has adopted so many measures to delay the full impact of its over-borrowing in all sectors. We remain invested in a mixture of Asian equity for growth, world property for recovery, and corporate bonds for income. The higher the western markets rise the more nervous we become about prospects.

The costs of investing

03/11/2009 00:00:00

The Financial Times has been commenting recently on investment managers who cut costs and offer simpler indexed solutions. They seem to like the idea that you can index investments in individual asset classes and share markets, whilst making choices and decisions about how much to have in each of the major categories. In practise they seem to support exactly what we have designed for investors: dynamic asset allocation, making big picture decisions for portfolios, combined with strict control of costs when it comes to buying the shares or property or bonds.I was therefore disappointed that they seem to misunderstand our full offer. They argued that the problem with our service was that it offered what was needed for larger funds over say £1 million, but was not available for smaller sums. How wrong they were.It is true we need to charge a minimum fee of £10,000 for a bespoke portfolio with good service levels. This means the bespoke service is unlikely to make sense for sums under £1million. That is why we have set up our service to Independent Financial Advisers. For the modest fee of just 0.25% we can offer them our dynamic asset allocation, implemented by buying Exchange Traded Funds in the relevant asset classes and markets. The IFA recruits and retains the client, providing the service and understanding how much risk they want to run. The IFA of course needs to charge the client for all that he or she does. We run the resulting portfolios by issuing the investment instructions. Our general system is run on the Ascentric platform, the vehicle for handling the cash and shares. We also have tailor made a similar investment system for Towergate, the national chain of independent advisers. We are very keen to offer our approach to all with savings and investments. In each case where we have been asked to offer our services recently we have been able to propose a reduction in the total costs of investment management. Judging markets and shares correctly time after time is difficult. If you charge too much for doing that you make the task impossible. Every fee, transaction cost and holding charge detracts from the performance and from the worth of the portfolio. Keeping costs down matters. We can keep our costs down for smaller investors by managing their money en bloc, whilst the individual IFAs provide the bespoke service.

Heading for choppier waters

30/10/2009 00:00:00

It has been an exciting six months in markets. Most asset prices have risen, as the world’s authorities have made unprecedented levels of financial support available to economies and banking system. The Chinese led the way with a massive budgetary and monetary stimulus. The UK and US authorities turned to buying bonds with money they created, to keep government interest rates low and to inject more liquidity into world markets. In Euroland the European Central Bank was a bit more cautious, but all banks at risk were handled to avoid collapse whilst the German government found ways to subsidise its hard pressed car industry. We recommended being invested in a mixture of Asian and world equity, world property through Real Estate Investment Trusts, commodities and corporate bonds. All have done well in this liquidity drenched improvement in capital values. As markets rose we grew a little more cautious, taking some profits on share positions and putting in more bond exposure where appropriate. The world economy remains badly damaged by twin crises. There is the western banking crisis, where many banks still need a long work out period to put behind them the mistakes of the past and get back to strong balance sheets. The authorities have made clear they will not let another major bank go down, and have put various banks on measures of support. The need to sort out balance sheets means slower growth in the worst affected countries like the UK and US. There is also the large imbalance between the saving and exporting countries on the one hand, and the spending, borrowing and importing countries on the other. These imbalances remain large and will affect future growth for both sides of the precarious balance. It will do more damage to the growth rates of the over borrowed as they seek to work off the debt. It is true that China responded well to the crisis by injecting large sums into its economy through monetary and fiscal stimulus. There remains the danger that China cannot stimulate sufficient extra consumption to take up the slack from more depressed western demand, and will concentrate too much on extra investment at a time of capital surplus. The US and UK will start to correct their balance of payments deficits as a result of the falls in the dollar and the pound, making imports dearer and domestic product better value. They will both, however, need to rein in consumption in public and private sectors, to curb the deficits. We are looking forward to a world where there will be more monetary and fiscal stimulus from authorities worried about a double dip or relapse into deeper recession. There will, however, also need to be some restriction on the amounts the US and UK can print and borrow, and some monetary tightening in the more successful faster growing economies, as we have already seen with a rise in interest rates in Australia. We expect the movement of economic power from West to East to continue apace, and for the more overextended western countries to find adjustment painful and difficult. Our portfolios will continue to place more emphasis on growth in parts of the world where that is likely to be faster and to continue. We will keep some money invested in bonds as some balance, given the huge uncertainties about the future growth and strength of the main western economies after the Crunch, and given the sharp recovery in share prices we have now enjoyed.

The UK remains in the banking doldrums

27/10/2009 00:00:00

The UK GDP figures came as a shock to the markets. Most forecasters had been expecting a small increase in activity after the long recession. Business surveys reported better news. The feeling abroad was the long de-stock was over. There were signs of life in the car and housing markets.Instead the figures showed the first signs of reality dawning in the previously ever buoyant public sector, continued gloom for manufacturing, weak performances in construction, hotels and leisure, and little progress in consumer spending despite low mortgage rates.The public senses that all the efforts to ease the situation are temporary. They know the money printing and bond buying cannot go on for ever. Companies are having to reduce their workforces even after the worst of the downturn has occurred. The winter looks set for major Union struggles against more aggressive management in a number of important cases. BA are having another go to cut the wage costs and manning levels in their airline. The Post Office is locked in a damaging row over work practises, dressed up as a dispute about "modernisation". A number of Council services are being challenged to become more efficient, leading to rubbish on the streets of Leeds and threats of strikes elsewhere. The iron law of the three huge UK deficits is a simple and remorseless one. Each sector in deficit, the banks, the public sector and the private sector, needs to cut its borrowing. Each will recognise that a substantial part of the adjustment has to be made by cutting costs. The banks are boosting income by putting up fees and charges, and are benefitting from the cheap money the government is supplying in abundance, but they have to rein in lending to get into balance. The public sector is putting up taxes, with proposed increases in petrol tax, Income Tax and National Insurance, but it is all highly marginal compared to the scale of the running deficit. They will have to cut spending. The government now accepts this but is delaying the timing of the first major cuts. The private sector has limited scope to boost incomes at a time of wage cuts, bonus contraction (outside the banks) and rising unemployment. Individuals are paying back credit card debt and even making some inroads into the amount of mortgages outstanding. That leaves less for discretionary purchases. Men are deciding they like the old car enough to give it another year. Women are seeing virtues in shoes and bags that have rested at the bottom of the wardrobe. All this implies slow growth at best. It also implies a long period of activity depressed by the overhang of too much borrowing. The government rightly says that if they can stimulate more rapid growth that would speed the adjustment. If the economy recovered swiftly that would bring in more tax revenue to cut the government deficit, generate more income to cut the private sector deficit, and allow the banks to generate more profit to improve their balance sheets. The problem is the most likely source of such growth, more borrowing to pay for the extra cars, houses, business ventures, is largely ruled out by the weak state of the banks and by the overhang of debt throughout the economy. Some in the government would like to think they could play the old game of getting UK people to borrow more one more time to lift us, but the banks are still weak and the economy as a whole so soaked in debt to make this difficult at best and dangerous at worst. So what is likely to happen? There will be a recovery of sorts at some point. You cannot de-stock for ever. Mortgage rates are very low so there is some spare money around. There are now profits to book from asset markets. Last quarter's figures may even be revised up a little in due course. Many analysts would like that, to make their error less remarkable. The Chancellor has always said he expects a recovery of sorts to begin around the turn of the year. This would suit the political timetable, allowing the government to carry on with many of its special measures until close to the election.The future of the UK economy rests more than ever on what progress is made with restoring the banks to health and more normal activity levels. All the time their Regulator insists on more cash and capital for current levels of lending there will be restrictions on new lending and a low cap on UK growth. The public sector will remain better protected through the mechanism which will require banks to lend more to the state in the years ahead to hit the higher liquidity requirements, but it too will have to cut spending. The cuts when they come, whoever is in government, will be larger than anything we have seen before. Concentration on boosting public sector efficiency will produce more bruising strikes and discord with employees, in the name of protecting front line services. Individuals against this background are likely to remain more cautious than in the heady days of 2005-7, and will understand that at some stage interest rates have to go up.The long term rate of growth of the UK economy over the next decade will be below the trend rate of the past 60 years. There remains the danger of disappointment at any time, as the economy is vulnerable to shocks. Once you are over-borrowed, there is no quick and easy way back. Governments need to keep the confidence of international money lenders, and need to avoid a further sterling devaluation.

The Way of the Future - "Big Picture Investing"

23/10/2009 00:00:00

We are bringing out a new edition of "Big Picture Investing", our guide to asset allocation and Exchange Traded funds.A lot has happened since we produced the first edition in 2008. Markets have dived and then rallied. The remorseless movement of activity, energy and raw financial and industrial power to Asia has continued. Interest in Exchange Traded Funds has grown strongly in the UK, and continued apace in the USA. More and more investors have become disillusioned with active managers who promise so much but have often delivered so little. In this cost conscious world where everything that costs a business or a charity money is under review, Trustees and investment committees are asking if there is a better and cheaper way to do things. More investors are coming to appreciate that their current portfolios reflect the old world of US and European dominance, not the new world of Asian led growth.Our ETF guide illustrates that many of the funds are growing in size following the increase in demand. Many are doing well at offsetting quite modest costs so the overall tracking error is small. We would like to see more downward pressure on the costs of ETFs in the more exotic markets, and expect that will materialise from more competition. They still remain much cheaper than their actively managed counterparts.The percentage declines and rises in main markets in the last two years have shown just how dominant market changes are in determining returns. Any fund which held substantial investments in US and UK shares through 2009 and 2010 is likely to have had a disappointing time. Any fund which used cash and bonds in 2008 to avoid the worst of the downturn should have done well. Holding Asian equities throughout was better than holding the developed economy shares, but better still was to avoid the credit crunch collapse. The extraordinary and difficult events of the last two years have confirmed our view that an investor needs to concentrate on the big picture. You cannot avoid an asset allocation. There is no perfect or long term right answer to asset allocation. You need to work away at judgements and assessing risks. You can avoid the higher costs of active management for shares. The last two years have shown how volatile and difficult markets can be, making it very difficult to find a successful active share manager. Our book of ETFs and asset allocation offers another way of investing. It should cut your costs of investing. With good judgement it can also raise your returns. Our suggested models for Pension fund investment can sometimes raise the potential return and lower the risk of the typical fund. That must be worth a look.

Bonus hopes disguise mixed outlook for UK property

20/10/2009 00:00:00

The UK housing market has shown signs of life in the last three months. Mortgage advances are rising from very low levels. There is a shortage of property on the market, so prices have apparently risen a little as poor demand puts strains on inadequate supply. After more than a year of hammering, with collapses in transaction volume and prices, many property professionals are understandably out and about talking up the green shoots of market revival.House prices were at their craziest in central London, in Belgravia, Mayfair and Chelsea. There they have performed surprisingly well. Foreign demand has stayed high, with overseas purchasers experiencing the frisson of bargain hunters. The twenty five per cent or so devaluation of the pound has made property prices look much cheaper to them. The £2000 a square foot top of the market property was $4000 or €2800. It is now $3200 or €2150, so it does not look so dear. The absence of bankers bonuses looked as if it would hit the next rank down, but this year the bonus revival is riding to the rescue of the Fulhams and Pimlicos. It is outside London that the markets have fared worse. The Midlands, with heavy manufacturing job losses has been much worse than central London.For years of boom the government told us the reason for high prices and rapid rises in price was the shortage of new building work. The Barker Review and its aftermath led to the government trying to force through more house building. Today the government appears to understand that the main driver of higher house prices was excess credit and money in the years up to 2007. Most of the homes on the market are second hand houses. Their prices rose as mortgage companies expanded the multiples of people’s pay they were prepared to lend, and as valuers responded with ever higher home valuations.Yesterday the FSA announced new controls on mortgage lending to try to prevent a re-run of the boom of the early years of this century. They wish to ensure better checks are carried out on individuals' incomes to tackle self-certification of incomes that prove to be unsustainable. They also want to rule out additional loan packages on top of the basic mortgage, as people sought extra cash to pay the Stamp duty, removal and furnishing costs and other items. These measures may make some difference at the margin, but the main cause of how much mortgage lending there will be is the way the authorities control the cash and capital of the banks. On current plans they wish to restrain bank balance sheet growth much more than they did in the heady days before the Credit Crunch. That will mean much slower house price growth or even further periods and areas of falling prices. House prices are about the amount of money available for purchase. A housing boom requires an expansionary banking sector, which we still do not have.Meanwhile commercial property in the UK has fallen further. There is still more building to be completed to bring more City offices and other developments on stream. We have seen a big expansion of retail space in recent years. There are large amounts of empty property in many towns, and downward pressure on rents. UK property, for long a prize asset for pension funds and charities, is not as strong as it once was. We may still have a legal structure based on restrictive planning controls and upwards only rent reviews, but we have for the time being too much property for the very restricted growth rates in prospect. The money being created by the Bank will wash into all types of assets, but we prefer property overseas where the yields remain attractive without some of the special problems we see in the UK market.

Is the only way up?

16/10/2009 00:00:00

It's been one of those unbelievable weeks. A client phoned to ask if the valuation was right because it seemed to be too high. (Yes, it was right). Markets continued their move upwards. Commodities rose, US shares rose, UK shares rose, Asian shares rose. It makes being an investment manager seem easy. If only. You should have made money when most things are going up rapidly. It is always important to remember pride comes before a fall. A rising tide raises all boats, but after a bit the ones that are holed below the waterline sink. Underlying the client's question was another good one. Can markets continue like this, given the poor news background out there in the factories, offices and shops of the global economy? The bulls say "Yes, it can". They say the sky is blue all over, so it cannot rain. Interest rates are low, the US and UK are printing money, the worst of the banking crisis is behind us, profits will start to rise, inventories cannot be run down any more, governments are stimulating activity. Go out for a long walk in the market, and don't weigh yourself down with a mac and umbrella. To them it's a win win bet. If all goes well, the economies will enter a self sustaining recovery, and the special stimuli can be slowly and gracefully withdrawn. The money making machines will turn again naturally, without quantitative easing. Turnover and profits will rise, rents will be paid and dividends start to go up. If that does not happen, it just means there will be more money printing and persistent low interest rates, so markets will rise in anticipation.The bears say this crisis is by no means over. The next move in interest rates will be up. That has already happened in Australia and may have to happen elsewhere in Asia. It could be forced on a country like the UK if currency markets lose confidence in policy. Some of the big US and UK banks are not mended. That means slow growth ahead, and more capital required. It means less lending. Unemployment may rise some more and wages stay down, limiting consumer demand. The big imbalances between the exporter high savings economies and the importer high borrowing economies have not adjusted much. The heavily indebted countries like the UK, Spain, Ireland and the USA have to start paying off debt. Real incomes will be squeezed, consumer spending will be constrained, and growth will be slower than before. Quantitative easing has to end, and that may drive down government bond prices, raising interest rates. The countries with the biggest deficits will be required to cut spending.So who us right? Both may have some truth in what they are saying. In the short term it may continue as a one way bet. There could be a change of mood or an accident in the riskier countries any time. So we think now is the time to cut the risk of a portfolio a bit, and to make sure you are oriented to the stronger countries that do not have to tackle huge deficits.

Asset fire sale won't extinguish UK debt problem

13/10/2009 00:00:00

This week we heard from the UK Prime Minister that he plans £3 billion of government asset sales, and a further £13 billion of local government asset sales, to help with the UK's budget deficit problems. It served to remind markets of the magnitude of the task. The £3 billion from central government assets will only meet the Treasury's needs for six days, then it is back to borrowing again. The £13 billion requires the willingness and drive of many Councils to see it through.Meanwhile the big numbers remain the Bank of England's quantitative easing programme and the borrowing requirement, both currently at £175 billion. The Bank will have to decide next month whether to ask the Chancellor for permission to increase the QE programme again. They will be tempted to do so, as the government is keen to engender more feel good before the election, and the Bank remains preoccupied by the threat of deflation. There is a danger of the borrowing growing of its own accord. There is little sign yet of austerity breaking out in Whitehall or Town Hall. The Prime Minister remains wedded to the notion that any premature reduction of spending would be bad for the recovery. His Finance Minister is not so sure, showing concerns for the size of the deficit and its affordability.So far the strategy of requiring the main banks to lend more to the government in the interests of increasing their holdings of liquid government bonds, allied to the substantial Bank purchases of second hand gilts, has allowed the deficit to be financed easily without official interest rates rising. Some strain has been felt on the currency, which has been falling again this month against most other currencies. The Bank is preoccupied by the recession, and seems quite relaxed about the inflationary consequences of the lower pound, and higher taxes, commencing with the 2.5% increase in VAT at the year end.The presence of so much easy money and low interest rates worldwide continues to drive most asset prices higher. Share prices and commodity prices are well ahead of real recovery in the underlying economies. The fall in the dollar and the pound should have some favourable impact on the large balance of payments deficits of those two countries. It also means tougher conditions in export markets for the leading export economies. The end of ‘cash for clunkers’ schemes in the US and Germany will dampen the reviving car markets.We are remaining fairly fully invested, but are giving more emphasis to higher yielding high grade corporate debt and less to now low-yielding equities, given the pace of the rise so far this year. The tide of easy money does raise most boats. It will also reveal some that were so holed they cannot float again. We think the risks in the UK, with the treble deficits of the private, banking and government deficits remain high. The banking crisis may be under control, but the West seems destined to live with impaired banks for some time to come. Many of the underlying problems in their asset portfolios remain to be sorted out. The combination of easy money and state guarantees is no substitute for banks working their way through their complete asset portfolio and establishing a firm base of performing loans from which to make a profit.

Tough rules for banks and tough choices for Government

09/10/2009 00:00:00

On Tuesday the FSA announced tough new rules for banks to keep more liquidity. They tightened the rules on what qualifies as a liquid asset, and will over the years ahead require more liquid assets to be held. The bottom line is that banks will have to lend much more to the government, buying government bonds to do so. The FSA’s guide figure was for an increase of £110 billion in bank holdings of government bonds, but other commentators think it could end up considerably higher than that figure. Banks may also need to sell some corporate bonds to make room for more government paper. In normal circumstances you would say “buy government bonds and sell corporate bonds”, as this is a major change to the demand side of the supply/demand equation. In practise gilt prices changed little. This was probably for three related reasons. Firstly, UK government bond yields are already low compared to past experience and relative to corporate bonds. Secondly, investors are well aware of the large borrowing requirements lining up for future years, so they see no need to rush to buy more gilts. Thirdly, they want to know what will happen to government bond prices when quantitative easing stops. Just ending the automatic purchase of large quantities by the Bank of England could damage prices. Any attempt to sell off the £170 billion portfolio would also have a big impact. We do not regard the new bank rules as a reason to recommend gilts again. We still think the extreme conditions of UK policy suggests to cautious investors to stay clear of UK government bonds. There should be easier ways of making money than lending to such a highly borrowed government at 4% or less. We also need to ask what might happen in the UK after a general election. The last two weeks have seen the main political parties at their conferences. The Labour government has now accepted that there do need to be cuts to start to bring the deficit under control. We will learn more of their plans at the time of the Autumn Statement. What is clear is the spending continues this year. They claim to want to halve the deficit subsequently but have not yet spelt out the detail of how such a big gap can be closed. The Conservative Opposition has stated that it wishes to start curbing the deficit immediately. It has now spelt out some proposals that will reduce spending, including raising the retirement age and placing a freeze on most public sector pay. It has also said it will still introduce higher state pensions. There is nothing yet on the table from any political party that would dramatically cut the deficit in a way which would drive bond prices higher and yields lower. The issue is whether the Opposition has said enough to prevent rates from rising, which is likely on unchanged government policies. You cannot solve a crisis brought on by borrowing too much, by just borrowing more. You cannot solve a banking crisis by simply transferring all the losses and toxic debts to the taxpayer. You cannot sustain a recovery on excess public spending and borrowing. The problem now is crowding-out. The government is putting everything through the public sector, starving the private sector of the cash and credit it needs to get moving again. The main risk is that markets will lose confidence in government borrowing and in the currency at some point, devaluing the pound more, forcing higher interest rates and more cuts. The government has to help the country tackle the treble deficits - past excess credit in the private sector, present and future excess borrowing in the public sector, and broken and over-extended banks. You cannot have a sustainable recovery until the banks are mended and able to advance money to the private sector again in sensible quantities at affordable rates. So what does the government need to do? 1. End the requirement on the banks to make such a large increase in their holdings of government debt. Higher bank liquidity should wait until the banks have worked out more of their bad debts and have strengthened their capital through retained profits, asset sales and share issues. 2. End Quantitative easing. The Bank's strategy is punishing the pound and pushing up asset and commodity prices very early in the cycle. 3. Implement a first round of sensible reductions in spending. At the very least it should end new pay awards to the public sector, reform welfare to encourage more back to work, and impose a staff freeze on all non front line posts. Markets want some sign that government is going to get a grip on its spending. 4. Bring forward asset sales, and accelerate the transfer of banks back to the private sector, splitting up the monoliths. 5. End the idea of government insurance for the bad debts of the banks and make them find private sector solutions to those problems. The authorities would continue to act as lender of last resort and to stand behind the deposit guarantee scheme. This is likely to include the weaker banks raising more capital from markets and selling more assets as a matter of urgency.

Markets fear the squeeze

06/10/2009 00:00:00

As we feared, there is a wobble in the main equity markets. Some traders are taking some profits. Some commentators are noticing that there is a big gap between what share prices are forecasting, and the present economic experience on the ground in the US and UK. It is a good time to look again at the big picture in the UK and remind ourselves why we are still cautious about UK assets.For the private sector to be too much in debt may be careless. For the public sector to be too much in debt may be inconvenient. For the banking sector to be too much in debt might be worrying. For all three to be too much in debt at the same time is dangerous.That is the position of the UK today. The boom phase encouraged excess debt in the private sector. Now individuals are busily repaying credit card debts, mortgage advances are well down on peak levels, companies are being forced to repay debt out of cash flow and asset sales or raise more money from shareholders. The private sector has been told in no uncertain terms to spend less and pay back more. The message is reinforced by high interest rates on most private borrowing, by scarce credit, and tough banks.The government also used the boom to expand its borrowing, particularly off balance sheet. It set up lots of Public Private Finance Initiatives, Public Private Partnerships and other routes to disguise public borrowing. It expanded its workforce and raised public sector salaries substantially, greatly increasing the public sector pensions deficits, and the costs of future unfunded pensions. Since the Credit Crunch it has expanded its conventional borrowing substantially.The banks, encouraged by their Regulators who allowed bank balance sheets to expand, increased their lending and then multiplied its effects through a large number of new complex financial instruments.As a result we have a country weighed down by huge debts. The challenge for the next government is to help all sectors chart a course out of excess debt.The private sector will adjust its own demands. There is already evidence of people doing just that, with credit card and mortgage lending falling. This process will unfortunately be speeded by the increases in unemployment that are happening, and by the interest rate rises to come.The banking sector can also cut its leverage. The government owner of two major banks should be tougher in demanding cost reductions, asset sales and other mechanisms to get these banks into a stronger shape more quickly without recourse to public subsidy. The UK economy will not work well until the banks work well. RBS and Lloyds have been offered substantial new capital and guarantees, delaying the necessary cost adjustments and business improvements they need to make. Which leaves the government sector. The three largest political parties all now agree that government needs to cut its spending. All agree that government can be more efficient and should strive to do more for less. Each party has identified a few items which they would like to see cut out of budgets altogether. That is a start.The problem is the magnitude of the tasks. If markets are to remain optimistic there needs to be a clear course for cutting these excessive borrowings. A strong economic recovery would help curb all three deficits, swelling personal incomes, adding to company profit and cash flow, cutting the numbers of unemployed and helping banks win profitable business. This can only happen if there is general confidence in the economic policies being pursued. The treble deficit strategy is a high risk one. If these three deficits are not visibly coming down soon, it will mean higher interest rates and more difficulty for the UK to borrow money, which will be bad for the recovery as well as for the main borrowers.It is going to take time to adjust the large imbalances around the world. The high savings successful exporting economies have problems as well, but these problems are not quite the same as having to finance three very large borrowing requirements as the UK has been doing. Something will get squeezed. So far it has been the private sector.

Easy money won't last forever - potential problems lie ahead

02/10/2009 00:00:00

The IMF Report on the world economy has caught up with private sector forecasters at last. After a poor two years first ignoring then worrying about the scale of the downturn, the IMF now expects a resumption of world growth of around 3% next year, with the Asian powerhouses providing the lead. Let’s hope they are right this time. If world growth disappoints, world share prices are now very exposed. We are living through a period when the economic news is being forced to catch up with events in financial markets, by the strong and favourable impact of easy money on asset prices. As a result of the rush into risk of the last half year, shares are now much more expensive than last March when they hit a bottom as fear and tight money gripped markets in a vice like grip. Commentators are dashing to discover good news to justify the prices.The IMF Report reminds us that the banking crisis is not yet resolved. Whilst few now expect further collapses of major banks, there is likely to be a long period of work out whilst the banks adjust to the tougher capital requirements being placed upon them. The Report draws attention to the particular problems of the UK, where a large banking system relative to the size of the economy, co-exists unhappily with a very overextended consumer sector trying to repay debt, and with a government sector building up its own borrowings at a huge pace. The existing banks do not have the capacity to advance all the money the economy needs.The temporary expedient of Quantitative Easing cannot go on forever. The present system ensures plentiful funds for the government bond market, allowing the state to borrow as much as it likes. Market interest rates for the private sector are much higher than the indicative rates set by the Central Bank. As the IMF rightly warns for the UK “non financial private sector credit will contract or barely grow during the remainder of 2009 and the first part of 2010” as all the pressure is placed on the private sector. The banks are being forced to restrict private sector lending to improve their capital ratios in a hurry. They are taking advantage of the current conditions to increase margins on what new private lending they do undertake. In the USA the improvement in share prices now takes the S and P to a position where it is only producing an income yield of 2.4% and is valued at 16.9 times earnings. We do not think this represents good value for investors, given the real problems that still lie ahead for the US economy. We recommend low or no exposure to US shares at these levels. In the UK the yield is a better 3.33% and the earnings multiple a fairly demanding 13.27, but the problems of the UK economy and currency are more extreme than the US ones. It is true the main companies are global and have a mixture of businesses and currency receipts, but why not invest completely abroad if you are concerned about the specific UK risks.Our preferred investment areas of China, India, the rest of the Far East and emerging markets are becoming very fashionable. All the time easy money flows it has to go somewhere. We suspect it will fuel even stronger performances in markets where there is a good prospect of better growth to start to lower earnings multiples again as companies make higher profits. So we recommend running positions in these areas, but are happy to hold a bit more in higher yielding corporate bonds to cut the risks. The higher the markets rise the more risk there is. We need to remember in these heady days that the banking problems are not yet solved. The world is making slow progress in tackling the huge imbalances between the exporters and the importers, between the saver and the borrower economies. There could be more pain ahead, especially when they start to switch off the easy money.

How to make defeat look like victory

29/09/2009 00:00:00

The German elections marked the end of the Grand coalition between the Christian Democrats and SDP. It was a dreadful night for the SDP, down at 23% of the votes cast. Frau Merkel's CDU also lost votes and vote share, coming out with just one third of the votes. The two main parties that dominated post-war German politics slumped to under 57% together. The Greens, and the radical left took away SDP votes. The Free Democrats scythed in to the CDI position.What were German electors trying to tell the two main parties? They were saying that their efforts to appear the same as each other and to govern together in a consensual coalition on the so called centre ground was the last thing voters wanted. They did not think it was good for Germany. The larger group of critics of the Grand coalition sided with those who want less government, lower taxes and more freedom. The smaller group sided with those who want more government and more centralised leadership and more green policy. The most interesting thing in the election was the great success of Guido Westerwelle, the leader of the Free Democrats, in boosting his party’s support. He condemned the car scrappage scheme as an expensive nonsense. He called for a cut in the top rate of tax from 45% to 35% to make Germany more competitive and enterprising, and a cut in the lower tax rate from 14% to 10% to cut poverty and boost private spending. He said of the Grand coalition it was only grand at "raising taxes and accumulating debt. It has frittered away billions in tax money.” The Free Democrats want to strengthen civil liberties, reduce state power and keep nuclear power stations. Frau Merkel now has to decide what she wishes to do. Early indications are that she will try to tone down the pro-business pro-freedom radicalism of the Free Democrats, preferring to govern with the establishment and the central consensus as she sees it. If Herr Westerwelle ends up as Foreign Minister, it will be more difficult for him to exercise his economic radicalism. He will have his hands full trying to get German troops out of Afghanistan. Nonetheless, it does mean some strengthening of those international voices which wish to move more quickly to end special measures, curb public spending, and free private sectors to recover and compete - a very different approach to the Brown/Obama approach we have seen on offer at the G20. The G20 itself decided to delay new banking regulations, and to spend more quality time on the issue of Iran. The Communiqué said they now needed to find a sensible path to rebalance economies and in due course move away from special measures, without setting out any detail of how they might do this. Meanwhile, this week we need to watch the pound, which is has been on the slide thanks to comments by the Governor and the Bank of England, and thanks to the very easy money policy being followed by the authorities. Markets have a habit of forcing issues before governments would like to tackle them. We continue to advise clients to avoid UK commitments, to have equity investments in Asia and other emerging markets, and to shift gilts into corporate bonds for a better yield.

The True Cost of Investing?

25/09/2009 00:00:00

I was asked yesterday to work out how much active management costs compared to passive management through indexed Exchange Traded Funds. I revisited some long and complex literature from independents and academics to try to find an honest answer. It was where we began in the summer of 2007 when setting up Evercore Pan-Asset, thinking through what would be the best and most cost effective approach for clients. You can look at the Total Expense Ratios (TERs) which the FSA and the US regulators ask all to publish. These show that the TERs of active funds are usually 0.5% to 1.5% higher than the equivalents from ETFs. The Total Expense Ratio comprises the investment management fee, the administrative costs, and the legal and audit fees. In the case of US mutual funds the figures are set out in the latest Frontier Capital Report entitled "When is a Total Expense Ratio not a Total Expense Ratio?" Frontier Capital go on to argue that you also need to add in transaction costs within the funds, and the entry and exit costs for investors using the funds. They set out the resulting increases in total costs when transactions are taken into account. In the US a large-capitalisation equity fund incurs an average of 0.9% of costs on top of the average 1.3% TER, a small capitalisation fund 2.5% on top of a 1.6% TER, and an emerging market fund 7% on top of a 2% TER. They suggest that UK funds are dearer on average than US ones. There are also dealing costs in ETFs that need to be compared to the entry and exit costs for active funds, which should normally be lower. Ross Miller's paper entitled "Measuring the true cost of Active Management" seeks to tease out the underlying cost, given that a lot of active funds in practise are largely closet indexers, taking only small bets away from the Index they are trying to beat. He splits out the active part that is trying to make a difference, and works out expense rates on the active portion. This gives very high figures for the average fund, yielding an overall active expense ratio of 5.2% on a published TER of 1.26% for the 4752 funds he studied. This in my view exaggerates the true costs but makes an interesting point. The answer is that properly chosen indexed funds should be considerably cheaper than actively managed funds. Many active funds not only have higher TERs, but also incur more substantial transactions costs within the fund which you need to consider. Each case needs to be looked at in detail, as there is a wide range of costs in all types of funds including indexed ones. We look not just at the TER of an ETF, but more importantly at the tracking error after all costs. That, after all, is what the client experiences. Some ETFs have got this down to a very low figure of a handful of basis points where 1% is 100 basis points. You need to ask the same question for active funds. You need to look at gains or losses against the index after all costs. The average fund shows losses, as the costs are too high to offset. As our graphs on this site show, the typical experience of active management in given asset classes can be a loss of 2% per annum (200 basis points) against the index. There are a few active winners, but they don't tell you in advance which they are going to be! We would be delighted to look at your portfolio and to see how much partial and complete indexation we could cut your expenses by, even after allowing for a modest fee for ourselves!

Beware the Banks

22/09/2009 00:00:00

The market collapse in 2007-8 was the result of poor monetary management in the US, the UK and parts of the EU in the last five years. The boom-bust approach created bloated banks which were then severely weakened by the shift to tight money. It is of little present importance whether you belong to the group who blames the bankers for being too greedy in growing their businesses beyond the prudent, or the group who blames the monetary authorities and regulators who encouraged the boom by low rates and easy money then helped bring on the bust by higher rates and demands for more capital. We are where we are. Apportioning blame is part of the political process. Parties of the left will tend to blame the bankers more, and parties of the right or more favourable to the markets will tend to criticise the authorities more. The common ground between both groups will doubtless lead to some more banking regulation and some more monetary innovation, as all political parties in power will be keen to avoid blame being ascribed to governments. They will see legislating more as proof they are concerned and keen to prevent a recurrence. There will be limits placed on how far they go in regulating by a growing understanding that big banks are global and need to be regulated by more than one jurisdiction. There is also a tangible nervousness about recovery, so more efforts will go into creating and fostering easy money than in more immediate further restrictions on banks. So far governments have concentrated on criticising banking bonuses. They claim they encouraged too much risk taking. Governments have been reluctant to try to ban bonuses in new laws, and have often acquiesced in new bonus arrangements in banks where they are the owners or have significant stakes. The difficulty for demand in the world economy is that the main debtor countries where the banks are weakest will find it difficult to crank up their borrowing again as their banks remain overstretched and their Regulators keen for them to improve their capital ratios. We are living through a strange period where huge sums of money are being created in the US and the UK to make markets more liquid. Money is rushing into asset markets, driving up the prices of shares, bonds and commodities. That same money is not rushing into bank lending to consumers and companies. The banks remain weak, unwilling to increase loan books. Customers are keener on repaying debt, worried about the possible loss of jobs, concerned that one day interest rates will go up again, and thinking about possible increases in taxes. The banks have to lend the money back to governments with a large appetite for new debt. In both the UK and the US there is now active discussion of the need to cut public sector spending, but still little sign of action to do so. Both governments hope that making statements about the need to curb the deficit by cuts in spending sometime will be reassuring enough. The UK administration is not keen to make cuts with an election pending, whilst the Obama administration is keen to press on with its increased spending plans for health, as its political priority.The truth about both the US and the UK is they have to rein in spending, export more and repay debt. The private sector is having to do this already. If the public sector does not make the adjustments soon, long-term interest rates will be forced up and the private sector will be hit again. We have avoided UK equities for some time, and are taking profits on some US positions. We still prefer Asian equity, where the growth is better. Returns so far this year have been good, so why not put some more of the money into bonds, to cut the risks?

UK government bonds still vulnerable

18/09/2009 00:00:00

The Governor of the Bank of England is still worrying more about output than prices. The inflation figures are still poor for the UK, with more price increases coming through from weaker sterling, and from companies determined to limit the damage of poor volumes to profits and cash flow. The Governor himself admits that price increases on the government’s chosen measure of CPI may well go above the target of 2% again when the VAT rate rises at the end of this year. The Bank is speculating about negative interest rates or penalties on banks hoarding their cash. This is a strange question to be discussing, at a time when the Bank’s twin banking regulator, the FSA, is demanding more cash and capital from the banks in the interests of prudence. The banks are unlikely to increase their lending in the UK any time soon, because their Regulator wants them to strengthen their balance sheets. If the Bank of England wants faster loan growth they need to have a persuasive word with the FSA. There is another reason why loan growth will be subdued or non-existent. Many people want to repay debt. They are frightened at the thought of losing their jobs, which might make loan payments impossible. They are concerned that the current very low interest rates sometime will come to an end, and worried that they will not be able to afford their large debts if interest rates go up too much. Many people share a new wish to be prudent, which will keep loan growth modest and spending under control. That in a way is exactly what the authorities wanted to achieve when they set out to halt the credit boom in 2007. Now they are concerned about the impact on jobs and output. Policy makers are making slow progress in correcting the huge imbalances in the world economy. All experts agree that the saving countries need to spend more and the spending countries need to borrow less. Meanwhile, attention remains turned to whether the US can manage another bubble to keep world spending and asset prices rising. It is true that China and India are stimulating their own economies and generating more internal demand, which is welcome. It is also true that markets are now pricing in US recovery, leading to a stronger world economy, as the easy money finds its way into risky assets first. Our combination of Asian equity and western corporate bonds in portfolios is generating a decent return in these conditions. Purchases of property ETFs are also working out well. These vehicles are moving ahead of improvements in western property markets, as the underlying shares were sitting on large discounts and generous yields even allowing for further falls in rents and capital values. We need to watch out for signs of monetary tightening, which would bring these strong markets to a halt. There will need to be fiscal tightening by the high borrowing countries quite soon. If there is not, expect the strain to be taken first on the exchange rate, and subsequently on the interest rate, once quantitative easing programmes have ended. Government bonds prices in the US and UK are what the authorities want them to be. They cannot carry on doing that for ever. At some point they need to stop buying and give the market a bigger say in settling the prices and yields. We still advise avoiding US and UK government bonds.

Enjoy it while it lasts

15/09/2009 00:00:00

Emerging markets up, commodities up, gold up, bonds up, and even advanced economy shares recovering. It’s an investment manager’s paradise, where all can be winners. The usual rules have gone out of the window. All assets are correlated. They turn out to be guided by easy money. This is the quantitative easing boom. At times like this investors should become more alert to risk, not less vigilant. It is easy to get sucked into the idea that there are good reasons why all these assets should get dearer. It is comfortable to think this is just a normal cycle, only a bit bigger with the asset price recoveries speeded up. It is not. It is possible rising markets continue for longer. That will depend on how much longer the main governments continue with ultra low interest rates and with easy money in money markets. The UK is going to do so for the rest of this year, and President Obama seems in no hurry to stand down the special measures. It also depends on how much longer markets will let them do this, and for how long investors will ignore the need sometime to adjust the world economy to better balance. Those who want to run equity risks should continue to do so. Those who want to ensure a reasonable real return should be taking some profits as the markets rise. Money put to work in the first half of the year has already earned very good returns for people. The US, the UK and the other big debtor countries will one day have to drop buying up their own bonds, and find out the true price of borrowing all that money in the markets. That is likely to mean higher long-term interest rates, which will be bad for bonds. The successful exporting economies like Japan, Germany and China, will have to discover new markets to replace the distressed US and UK consumers. We are in for months and possibly years of the US and UK consumers paying off debt and being reluctant to borrow. Sometime the countries that are borrowing too much will have to rein in their state expenditures. Many more forecasters are coming round to the view that Asia will perform better than America or Europe. Despite that, most portfolios I see still have large positions in US and UK shares, and small ones in Asian equity. Asia has outperformed well this year, but the long-term case remains very strong. We are offering to put money into Asia quickly on a passively managed basis for larger funds that are still underexposed, as we think it makes strategic sense to do so. We can manage the country exposures and watch for worrying signs in Asian markets for Trustees.

Easy money and broken banks

11/09/2009 00:00:00

Low interest rates usually fuel recovery. Higher interest rates check booms. We are now approaching the anniversary of much lower rates in the UK and US. Sure enough, on cue, first the surveys then the output figures start to show improvement from the lows of the first half of 2009. It is what you would expect. There are two complications in this cycle. The first is the extremes which the monetary authorities have placed on markets. Markets were kept remarkably tight, short of money a year ago. Now there is unprecedented money creation in an effort to ease things more rapidly. This would point to a stronger and faster recovery, if all things were equal, from the severe slump the monetary tightening understandably produced. The second is the state of the banks. Because many large banks entered the downturn in weak shape, with poor levels of capital and cash, they will not be able to lend on as much as normal as more money is created. Indeed, this problem has been augmented by the decision of banking regulators to demand more cash and capital at this stage of the cycle, reinforcing the problems the banks have in growing their lending.Those who mainly see the first problem expect further rises in share prices, as the easy money finds its way into assets. They also expect a V shaped recovery. Those who are more preoccupied by the second problem fear a U shaped recovery, or even a double dip recession or a prolonged L shape, with little positive growth. It is not yet clear how the balance of forces between easy money and broken banks will work out. It does seem likely, however, that a heavily indebted country like the UK will struggle more than better placed countries and more than in the recent past to sustain a lively pace of growth. A few months ago it was fashionable to expect deflation. Prices in many countries started to fall. The extreme monetary tightness and the collapse in activity suggested a long period of price falls. More recently some have queried this outlook, especially for the UK where price rises have continued as measured by the CPI across the worst period of recession. The weakness of sterling last year led to imported inflation. The government sector has continued to put up fees, charges and petrol tax. Some companies have decided to hold or increase prices despite poor demand, arguing that they will not gain volume anyway so they may as well recoup a bit more cost from price. The Monetary Policy Committee of the Bank of England concentrates on the alleged output gap. They reason that the economy is producing well below its capacity, so they think price increases will stay under very good control. They should worry a bit more. More companies might decide to recoup on price what they cannot gain on volume. More capacity may be destroyed more rapidly, as companies seek to reduce cost and create more pricing power. Commodity prices have already shot up from the lows, despite low world output, as speculators and the Chinese have stockpiled more in anticipation of higher demand. Easy money is here for a bit longer. This is generally good for asset prices. The banks remain damaged, which is bad for growth. The large public deficits in the US and UK need to be addressed at some point. Interest rates cannot remain this low indefinitely, especially where governments need to borrow large sums of money. We remain happier with Asian equity than with UK.

Risk appetites - how hungry are you?

08/09/2009 00:00:00

It is popular at the moment for market participants to say “Investors’ risk appetite is increasing”. They mean that as share markets rise, so more investors lose their fears and decide to buy. Quantitative easing is providing more money for asset purchase. The feeling that the worst of the banking crisis is behind us assists. Every figure suggesting that the worst of the economic decline is over helps build the bullish story. Investment funds for the retail market are graded according to how much risk they are running. Risk is usually measured by looking at past price changes for the assets the fund is invested in. Share prices go up and down a lot, so they are perceived as risky. Bond prices go up and down less so they are a bit less risky, whilst deposits in strong banks hold their value whatever happens. The problem with grading funds by risk and telling them to keep to those characteristics is that people’s feelings about risk change over time. If a client came with new money in March 2009, after a long period of collapse and decline, he or she might feel have felt they wanted to be very cautious. That turned out to be the time when you should have wanted maximum risk if you wanted to make money, as the risky assets were very cheap and about to rise substantially. A good adviser would have said, why not take some risk? A month or so later the investor might have seen that things were improving, and wanted to own more shares. If he had invested in a graded low risk fund that would require switching from one fund to another. Asset allocation advice for funds is based on this essential perception, that you might want to alter now much risk you run over time. It might be sensible – as we thought – to run very little risk in a year like 2008. A prolonged Credit Crunch was all too likely. We had seen the financial disasters in 2007 and thought there were many more to come. In 2009 it seemed a good idea to run more risk. Returns on cash had plummeted, and riskier assets had fallen a long way to discount the dangers. That’s why, for discretionary larger clients we have shifted portfolios from all cash to fairly fully invested, and why as markets rise we are taking some profits. For smaller investors we now offer investment advice to IFAs, so you can use our service through an IFA who has signed up. Today we are recommending a balanced approach, with a mixture of bonds and shares, as we have seen good rises in share markets. We think there are problems ahead for the large debtor economies which the markets have chosen to ignore for the time being.

Easy money matters more than bankers' bonuses

04/09/2009 00:00:00

It’s that time of year when senior politicians feel moved to save the world again. After long summer breaks, the Finance Ministers of the G20 meet today in London, to catch up on the promises of the last G20 summit which they have not yet fulfilled, and to consider what next should preoccupy them. The headlines are going to the vexed subject of bankers bonuses. Unfinished business from last time, there is now an attempt to cobble together some regulatory answer. The Finance Ministers missed their best chance of having real influence over pay and rations in banks. When they were distributing huge largesse last autumn to prop up banks thought to be in danger they could have written what terms they liked. Today, with the apparent crisis receding, it is not so easy. Given the divide between the US and the European positions, we may end up with more strong words on the need for restraint. There could be some attempt at a regulatory answer in the EU in the form of a requirement that some elements of a performance bonus should be delayed in payment. They will look long and hard at guaranteed bonuses. Any attempt to ban those would migrate such payments to other types of hiring fee for new staff, which is where the guaranteed bonus is most common. What we need the Finance Ministers to do is to look ahead more than they look backwards to the last crisis. Markets have been powering upwards on the back of easy money and low interest rates, supercharged by quantitative easing in the US and UK. Investors need more guidance on when things will be returned to more normal policies. In the UK government bond prices are mainly determined by the Bank of England’s purchase policy. What will happen to them when that ends? Where will short-term interest rates go, when quantitative easing is over? I read that some of the summiteers are nervous about making any public pronouncements on ending the special measures, for fear of tipping economies back into recession. Such briefing can be self-defeating, as it implies a lack of confidence itself. Market participants are canny. They know that the current extraordinary measures cannot continue indefinitely. It would help to put them out of their uncertainty by having a sensible plan to get back to more normal official rates and to end quantitative easing. One member of the MPC is now saying that official interest rates in the UK have to go up. He is the one realist. We have sold some US shares. The market there has done well in recent weeks, and yields are now quite low. Both the US and the UK face a difficult time when their governments recognise that large public deficits and borrowing programmes are no more affordable than the large private sector ones turned out to be.

The UK's debt overhang will hamper recovery

01/09/2009 00:00:00

The UK government used to tell us the UK was the best placed of the major economies to weather the "global storms". The government suggested the UK would be first out thanks to the massive public sector "stimulus" administered. They ignored the weakness of the large UK banking sector which was always going to take time to restore lending. They overlooked the highly borrowed state of UK consumers. The second quarter figures tell a different tale. The UK economy continued to fall, falling faster than the USA, falling faster than the stronger major economies which saw some recovery. France, Germany and Japan showed signs of rising output. It is true UK government consumption rose, thanks to the extra spending and the massive borrowing, which helped the figures for output. Overseas trade improved but little despite the devaluation of last year. The big reason the UK continued to fall was the continued squeeze on the consumer.The authorities brought the UK consumer boom to an abrupt end by their hikes in interest rates and their scarce money policies of 2008-9. They did so presumably because they thought consumers were borrowing too much and the party had to end. They got into a panic late in the day, cutting interest rates sharply and printing money to try to offset what they had done over the two preceding years. Meanwhile consumers are taking the hint they gave them earlier, and are busily repaying debt. That means they spend less. All the time people are highly borrowed - as they are - and all the time many fear unemployment - as they do - they will repay more debt than the government now wants and spend less than the government wishes. One of the reasons people are likely to stay cautious and repay more debt is the likely pattern of interest rates. Few consumers believe 0.5% rates. Firstly, most consumers cannot borrow at those rates. If you can get a loan it will be many times base rate. Secondly, most people expect rates to have to go up again. They have been burned by the past interest rate hikes. They realise that given the huge sums the government needs to borrow, higher rates are likely in the medium term. The government hopes to keep rates down through quantitative easing to see them through to near the election. Once that is out of the way markets are likely to force rates up on government debt, unless sufficient action is taken to rein in the deficit and the borrowing requirement. Meanwhile canny consumers will carry on paying off debt, and worrying how long they may keep their job. We think the UK deficit problems are an important block on the road to full recovery, and continue to prefer assets elsewhere during this period of easier money worldwide.

How to manage the Multi Managers?

28/08/2009 00:00:00

Many of the larger investment funds we talk to, charities and pension funds, employ several managers. This can bring them the benefits of different approaches to investment. There is no one right way of investing money. Multi manager approaches can provide diversification. When one or more of the strategies goes wrong, one of the others might work. Even in 2008 when private equity, property, and quoted equity of most kinds went down all round the world, a government bond portfolio made money. There are two main disadvantages to using lots of managers. The first is cost and complexity. You spend more monitoring them and meeting with them. They each need to charge you percentage fees based on the amount of your money they manage, rather than based on the full size of the total fund. This will tend to increase the fee substantially. The second is you can lose control over what really matters, the overall asset allocation. If you are hiring good managers whose skills you rate, you will usually give them considerable discretion. Your equity managers may have discretion over which parts of the world to be invested in. They may have some discretion over whether to be fully invested or not. Your bond managers may have discretion to be long-dated, taking lots of risk, or short-dated, taking much less. You may have managers who can mix how much they have in property, equity, cash and bonds as they make their judgements. At any given time you may have Manager A selling UK shares, and Manager B buying them, as a matter of policy. Those disagreements make a market, but your fund may be incurring some of the costs of both contradictory judgements. So what can you do to improve the position, whilst maintaining the best of your managers? We have thought long and hard about it at Evercore Pan-Asset. We are now offering a strategic asset allocation advisory service, allied to investing a balancing portfolio for the larger funds, so they can regain some control over the overall asset allocation and cut the costs of active management on a portion of the fund. An example shows how it could work. Let’s take the case of a £400 million pension fund. This fund currently has six different active managers and an Investment Consultant. If the fund allocated £100m to us to run as a balancing portfolio, all six existing managers could be kept if they are doing a good job within their sectors and markets whilst all surrendering one quarter of their money under management, or the decision could be made to drop one or two of them if their performance is poor. We would offer advice on the best disposition for the total fund, and would then calculate what the balancing portfolio should hold to bring the overall fund into that shape. The active managers would not be asked to change their approach or their asset allocations, but would just keep us informed of any major changes that could affect the overall balance, so we could adjust if necessary. In recent months we have favoured substantial investment in Asian and emerging market equity, usually placing around one third of the portfolio in such markets. The typical UK pension fund has around 5-10% in these areas, so we would have used the balancing fund to increase the overall weighting, probably using all the fund for such investment. In 2008 we recommended extreme caution, and would have usually suggested 100% of the balancing fund being in money market instruments or on deposit or in short-dated bonds. We could quote an overall fee for managing the £100 million in indexed vehicles which would usually offer a good saving on active management of that money, providing the investment allocation advice as part of that service within that fee. In the case of our £400 million fund, we would be happy to work with the Investment Consultant, who could still offer independent advice about our performance and stance, as well as helping with active manager selection. We suspect in some cases over the years Trustees and Investment Committee members would come to like the influence it gave them over the direction of the fund, and the costs savings on active management. Committee meetings could concentrate much more on reviewing the overall shape of the portfolio, and on the big picture decisions which determine how well the fund does. The Committee would be in receipt of continuous professional advice on asset allocation. If something important happens, as it did in August 2007 when the money markets froze, the fund would have a chance to respond quickly. Too many large funds only take allocation advice once in a while when it may be too late for the last disaster and too soon for the next. If Trustees do grow to like this approach, they can always increase the size of the balancing fund, saving more fees.

Don't forget income

25/08/2009 00:00:00

One of the things we look at closely is the income any given asset yields. It is part of our "Keeping it Simple" approach. For years clever investors have told their clients to look at total returns. If you are a charity or pension fund not paying tax you do not mind whether the gain comes as dividend or capital appreciation. If you are a high tax rate investor you prefer capital gain to dividend or interest income. This is all true. It also contains some dangers. Whilst it is true that buying a low-yielding share or market can make you good money on the capital gain, that is only likely to occur if the underlying company or economy is growing rapidly and just happens to be reinvesting more of the money and distributing less. It is not true if the economy or share combines low yield with poor growth. Then you are likely to do badly as a result. If the yield is low because that is all they can afford, beware. It is important to remember that the reason for buying company shares or properties is the income they yield, and the growth in that income. Investors for years have been prepared to accept a lower income on a share or even on a property than on a bond, because they expect the income to go up over time. That in turn is likely to result in appreciation of the capital value. The reason you seek rising asset values of companies is that reflects and helps create rising income paying power. One of the reasons shares fell so sharply in 2008 was the sudden realisation that dividends could go down as well as up. Property values fell, as people remembered that rents could stop rising, and space could be difficult to let at all. In the UK one quarter of all the dividend income in 2007 came from bank shares. There was bound to be a big fall in total dividends in the market, given the financial distress of some of the leading banks. Today stock markets are advancing strongly. It is time to ask how good is the underlying value at these levels? How much income can you enjoy? The surprising thing is how low yields now are, reflecting the dividend cuts alongside the share price improvements. Conversely, property yields and corporate bond yields are still much higher. The US market is now yielding just 2.5% and global equities just 2.6%. Bulls will say with cash at 0.5%, and with growth likely to resume next year, that is fair enough. Bears will counter that dividend growth may be slow from the bottom in the advanced countries, as their economies have to work through the debt overhang, and as their banks struggle to replenish their cash and capital reserves. So how does their yield compare with other assets? You can buy shares in emerging markets and in Asia on similar yields to the US, but growth should be faster. That to us makes them the better bet. You can still buy sterling corporate bonds of good quality on more than a 6% yield. That’s more than twice the yield on world equities, and seems anomalous. If the corporate outlook is as bad as the bond market still discounts, the outlook for shares will be far worse. You can buy US property through the ETF of property shares on a 5.4% yield, and Asian property on a 4% yield. There are still troubles ahead in the rental markets in some centres, but a lot has now been written off or written down. The income levels have fallen substantially in the last year. That implies to us the medium-term investor should do better in world property than in world shares. Rental income remains a prior claim to dividends. The company sector is unlikely to do well without requiring more commercial property and paying more rent. Although it is early in the cycle, the pace of share appreciation suggests to us property is now the better choice than equity markets. 2.5% yields may look fine whilst interest rates remain near zero, but they do not look so exciting compared to other yields available on property and corporate bonds. Yield Global Equities 2.6% US Equities 2.5% Far East (ex Japan) Equities 3.0% Emerging Market Equities 2.5% US and UK Property 5-10% Sterling Corporate Bond ETF 6.3% Source: Thompson Reuters/Financial Times

Carry on borrowing

21/08/2009 00:00:00

This week’s figures for UK public borrowing were bad. Market expectations were far too optimistic. Compared to the first four months of the previous financial year, revenues were down by £21 billion and spending was up by £19 billion. The UK government needed to borrow another £8 billion in July, a month when normally the government has a comfortable surplus. As we have been warning, we should expect more of the same in the months ahead. The economy is still weak, and more people are likely to lose their jobs. This is not a good background for increased spending and more demand. The VAT reduction ceases at the end of the year. The UK banks remain under pressure from the authorities to raise their cash and capital levels or to reduce their lending. They too do not offer an easy way of increasing private sector demand. Over the next few months the government will continue to be the spender and borrower of last resort. Why does this matter to investors? Isn’t it what they should be doing at a time of recession? Yes, they do have to spend more to deal with the casualties of the recession. Benefit spending does go up as more people lose their jobs, and revenues do fall as output and profits fall. Most governments use the so called automatic stabilisers by allowing more borrowing to cover these costs and losses. The increases in spending and the fall in revenues become a problem if the amounts that need to be borrowed become too large. If markets start to think the government cannot control its deficit, then investors will demand a higher rate of interest for the risk of lending. The higher rate will mean yet more public spending to service the debts. It may also mean a general rise in interest rates, which will hit private sector borrowers as well. So far the UK government has been able to borrow at relatively low rates, thanks to two favourable forces. The first is the programme of buying its own bonds, which has helped keep the rates down below where they would otherwise be. The second is that most market participants think the government elected probably in May 2010 at the next General Election will rein in spending. It is difficult to see how the UK can avoid some further increases in government borrowing rates, given the large sums involved. This means we continue to be negative about gilts, whose prices fall as interest rates rise. It is also difficult to see how the UK private sector can expand rapidly in domestic markets against this background of public sector crowding out. The weak position of some of the banks reinforces this view. World markets have had a wobble over the last couple of weeks. They have run up rapidly on the back of rapid money supply growth in China and India, and as a result of the large quantitative easing programmes of the USA and the UK. Reality has to catch up. The reality remains that the growth prospects for the USA and Europe are weak, whilst India and China still offer the best prospects despite the sharp decline in export opportunities. We think equity portfolios should reflect this differential outlook. New investors should be careful about when they commit money, as valuations are now building in quite a lot of good news and recovery prospects.

Keep it simple

18/08/2009 00:00:00

Sometimes the obvious gets ignored. It may be ignored for a long time. People can suspend disbelief. Markets can overshoot. Money drives asset prices, and we are living through a period when there is plenty of money around to buy risk assets. That is why we have been recommending investing this year in a range of risk assets, despite the poor economic background. It is also perhaps time to remind ourselves of the obvious. The US and the UK are going to take time to recover from the excess debt they allowed to build up in their banking systems and the wider economy. They both experienced property bubbles which have burst painfully. They both have overstretched consumers and some over-geared companies. They both have some large banks that need to rebuild cash and capital. In the UK the government has focused on getting through until May 2010, the likely date of the next general election. They have decided to spend, borrow and print what it takes to limit the downturn and engender some kind of recovery in due course. In the USA a new President came to office pledged to a bi-partisan policy of spending, borrowing and printing more. Once in office he decided to increase the amounts in each of those categories, hitching his fortunes to an additional spending package. Some Obama representatives are already talking of the deficit and spending problems being second term issues, as if they will wait that long. Both administrations are fighting fire with fire. They both think the answer to too much borrowing in the private sector is more borrowing in the public sector. Their answer to heavy losses in the financial world is to nationalise the losses. Their answer to insufficient demand is to try to stimulate extra demand by more public spending. The problem with this approach should be obvious. Every extra dollar or pound spent in the public sector has to come from the private sector (once money printing is over). It either comes in the form of extra taxes immediately, or in the form of tax increases subsequently to service and repay the debt. If it is borrowed in the short term the private sector has to lend them the money, which is money the private sector cannot then spend itself. Every dollar borrowed or taxed transfers spending from private to public, it does not create new demand. More public borrowing will squeeze out the private sector recovery. We can see this very directly in the UK. Most of the extra borrowing is being paid for by the banks lending money to the government. This means the banks have insufficient money left over to lend to the private sector. UK businesses are starved of access to credit on any terms, or on low interest rate terms in the case of the bigger and stronger ones. In due course, once quantitative easing is over, we may well experience further increases in interest rates, which are already well above the highly notional low base rate if you want to lend or borrow. The UK authorities are creating a money-go-round. The banks are made to lend huge sums to the government under the new rules requiring them to keep much more liquidity. The regulators define liquidity to include government bonds. The simple truth is this. If excess lending and borrowing were wrong for the private sector prior to the 2007 crunch – and they were – they are also wrong for the public sector. Indeed, it is even worse when the public sector does it, as the rest of us have no choice. We will just have to knuckle down and pay it off sometime. The longer the US and UK delay bringing the public accounts in to shape, the bigger the problem will be when the adjustment does start. If they do not show willing to do it in a reasonable time frame, the markets will do it for them. That will make us all poorer, as it will start with higher market interest rates, and continue with a further squeeze on the private sector. In the meantime there is no substitute for sorting out the banks. Subsidising them is not a good idea. They need to write off the bad, and get on with the new. There cannot be decent growth without expanding banks. The danger is that some of the “rescues” will delay the sort out.

Go East

14/08/2009 00:00:00

Recovery is in the air. Few are throwing their caps sky high to celebrate in the world beyond the excitable financial markets. German and French GDP came in a little higher in the second quarter of 2009, whilst the UK continued to fall. Most commentators anticipate a weak recovery starting in the second half of 2009, as they expect stock reductions to end. The Franco-German economies have been helped by import substitution and the government schemes to stimulate more car buying. Some company results on both sides of the Atlantic are better than expected by market analysts, largely owing to bigger cost reductions. Commodity prices have been moving up, as China buys her needs forward, and as investment and speculative money moves in early. Oil production has fallen, and sugar is in short supply. Shares in emerging markets have been outperforming advanced country markets, as investors respond to the likely prospects of faster growth there during any recovery. Large funds in both the UK and the US remain very light in Asia and emerging markets, and are realising they ought to adjust their positions. The negatives are still plentiful, but being ignored on the back of a wave of money from quantitative easing in the US and UK, and money from China and India as their authorities keep things loose and easy. In the UK unemployment is rising inexorably, and is expected to go above the 3 million mark by most commentators this winter. That is not a good background for either consumer spending and confidence or for house prices. In the US there are still doubts about the health of the real estate market in many parts of the country, whilst in both countries incomes are being squeezed. The UK and US public sector deficits continue to climb, with both governments committed to high spending policies against the background of weak revenues. Both the US and the UK are continuing with their quantitative easing programmes. The UK one is larger and they have the bigger problem of adjustment once they decide to bring it to an end. Many final salary pension funds are in deficit. We should expect further rounds of closing schemes to new members and even to further contribution from existing members, as companies try to cut their pensions risks. We remain committed to a combination of high grade corporate bonds and Asian and emerging market equity for discretionary accounts. The corporate bonds have been appreciating gently in recent days, to add to their attractive yields. More has to be done to tackle the large trade imbalances and government deficits in the major western debtor economies. There are better opportunities for investors elsewhere, without those same risks.

Markets run ahead of reality

11/08/2009 00:00:00

Equity markets have been rising on modest volumes. There has been too much liquidity chasing too few shares, despite the substantial new issues from undercapitalised businesses. The quantitative easing money from both sides of the Atlantic has been moving into riskier assets. Portfolio investors are less nervous about the future than they were at the height of the credit crunch crisis last year, or near the bottom of the panic about the real economy in March of this year. The upward movement in shares has been common to most markets, though Asian and emerging market equity as we hoped has done better. This reflects the light exposure most US and UK funds have to these parts of the world, and the sudden need to have more representation, as well as the bullish speculation in markets like China and India where domestic liquidity has helped fuel the share booms. It also underscores the reality, that these parts of the world should grow much faster than the west in the next few years. Equity investment in the end is about growth in dividends and asset values, so it makes sense for equity investors to seek out the faster growing prospects. The US and UK economies will turn round on the back of the large official interest rate declines, the quantitative easing, and the end of the violent de-stocking phase of the downturn. They will, however, be constrained in their future growth by the need to shift more resources into reducing the trade deficits and more importantly into paying back debt and reducing leverage throughout the public and private sectors. The US and UK governments have both decided to cushion the contraction and delay the adjustments they need to make by printing money and by running very large public sector deficits. At some point they will have to stop quantitative easing. At the same time markets may decide they want a higher rate of interest in order to lend money to these governments, triggering slower growth and more tensions within the economy. Commentators and some investors have justified the sharp appreciation in many share prices in three ways. They correctly point out that at the market low investors had many apprehensions about the collapse of the system, fears which now seem to be overdone. They argue that recent profits figures have been better than expected, with signs of revival in the banks and commodity linked companies as well as general trading companies. Careful analysis shows that in many cases the better earnings are the result of quick and drastic action taken to cut costs, rather than of growth in revenues and business, whilst the clearing banks are still reporting more write-offs and distress in their loan books. They go on to suggest that there will be a reasonable recovery from here. It does seem likely that the rate of decline will slow, and that the US and UK will respond to the huge monetary stimuli administered. It is also likely that there will be problems ahead, weaning these economies off these very large monetary injections. The dollar went through a sharp fall, but has rallied somewhat against sterling in the last couple of days. Both currencies are likely to weaken against the Asian currencies in the years ahead. US and UK government bond yields have risen from their lows. We still suggest avoiding them, as the full impact of their large issue programmes strikes home. High grade sterling corporate bonds have risen somewhat in the last couple of weeks, but we still recommend holding them as the yield differential between these bonds and gilts remains substantial.

The Quantitative Easing Share Boom

07/08/2009 00:00:00

Yesterday the UK Bank and government announced a substantial addition to its quantitative easing (QE) programme, to extend it well into the autumn, as we expected. This had a perverse consequence. After several weeks of successfully talking up the green shoots in the economy, the Bank felt the need to dampen spirits by stressing how bad things still are. It needed to do this to justify the extraordinary action it is taking. The UK QE programme has always been shrouded in some mystery or uncertainty. The Bank at first said it would lead to more bank lending. Then it said it would expand the money supply. So far it has not led to a proportionate increase in bank lending. If it has boosted the money supply, it has only done so against the background of arresting its fall. It is possible one of the main aims of the programme was to stop interest rates going up and to allow the government to carry on borrowing large sums at low rates. It has not even succeeded in achieving this, as rates of interest on government debt have risen in recent months despite the massive official purchases. They may, of course, have risen further and faster without this intervention. The idea of QE came from conventional monetarists. To them the aim was always to expand the money supply. They argue that so far it has enjoyed limited success, owing to the depth of the problem they are tackling. They favour doing more to expand money further. They accept that this may create asset price inflation. So far QE on both sides of the Atlantic has been good for holders of shares and commodities as speculative money and savings have flowed into riskier assets. The government, following this policy, could strengthen its case by announcing formal money supply targets, so markets could know what they are trying to achieve, and would have greater certainty over judging how much more quantitative easing there might be and when the programme might end. At the moment we have the unhealthy position that markets are unsure of the purposes of the policy and therefore of its ultimate extent. Markets do know that the prices of government bonds are now artificial in the sense that at some point the main buyer, the government, has to withdraw from the market. Yesterday it would have helped to have more answers from the authorities. How are they judging the programme and when will we know it has been successful? How do they work out the right amounts to inject? How long does it take for the full effects of this policy to be felt? Why doesn’t the Bank announce a formal target for money growth to be achieved under this programme? Does the Bank have any kind of interest rate target in its mind when it looks at the state of the bond markets? The announcement came as a shock yesterday to many market participants and media commentators, who had bought into the recovery and green shoots story. To be told by the Bank that the recession was worse than expected hit their confidence. To see the authorities judging they needed to do more led to different stories being written. Part of the art of getting us out of this long and deep recession is creating the right atmosphere. Confidence is a precious flower that needs nurturing. The authorities need to lead markets confidently, without changing the script more than they have to. The truth is that lower interest rates do work, and it always takes around a year for the beneficial effects from lower rates to come through. The big cuts in interest rates happened in the final quarter of 2008. The issue now is whether the Bank can manage bond and money markets to keep market rates down, at a time when their indicative and chosen rate of 0.5% is so far below normal transaction rates.

Riding the crest of the QE wave

04/08/2009 00:00:00

Isn’t quantitative easing a wonderful thing? Asset values surge on the back of easy money, whatever the outlook for the economies and companies. Scribblers rush to write that markets are rising because there is a profits improvement, or in desperation turn to the charts and say it is all because the chart patterns look good. Of course the charts look good – easy money is pushing up share and commodity prices. Profits are benefitting from the tough cost control action many US and UK companies have taken. Top lines are not doing well, as activity remains very flat. As we hoped, the emerging markets and Asia are rallying more strongly than the West, as their growth story is better. Ahead lies a modest recovery in the West, which will look better on some figures if only because last year’s comparisons are so dire. Also ahead lies the need at some point to stop money printing, and to recognise the need for action to tackle government debt. Last quarter’s GDP figures in the US were helped by strong public spending. The UK has still to take proper action to cut government costs. The UK is likely to run a loose policy right up to the election, whilst President Obama already seems to be thinking of delay in facing reality for the second term if only he can get there as big spender. At the moment his attention is on trying to win the votes necessary to increase US state financed health bills. All this is better news for shares than for government bonds in both the US and the UK. On 28th November last year we made our last positive recommendation to hold or buy UK gilts, when the 25 year yield was 3.8%. By early January gilt prices had risen and the yield had fallen to 3.1%. We issued the first of many warnings of the gilt bubble the government was creating, which we repeated at regular intervals in the first half of 2009. The yield on the 25 year bond has now risen as high 4.6%, with the consequent fall in the bond price compared to last November. Has it now fallen enough to take full account of the negatives? I fear not. The prices of gilts of most maturities have fallen despite the large government buying programme to buy gilts. At some point the government buying will cease. There has also been large purchases by banks, required by the new rules demanding that they hold higher liquid balances, which they usually hold in gilts. This too will moderate as they reach their new regulatory targets. Interest rates are well above the notional 0.5% level set by the Monetary Policy Committee of the Bank of England. Banks are rebuilding margins by lending at much higher rates and fees. The interest rates on lending to the government have risen and are likely to rise further, as the full horrors of the public finances become apparent to more people. The authorities will try to run with low interest rates for a long time, but in practise rates are rising as the market dictates they should. Banks need to earn bigger returns, and banks are determined to charge more for the risk of lending to both the private and public sectors. The authorities are restricting the amount of private sector lending by their more demanding new rules on banks cash and capital, thereby limiting competition. The biggest problem the market will face is the lack of any action plan to curb the deficit properly in future years. No UK political party has yet spelt out a programme of spending reductions that are up the task. No political party wants to talk about serious tax rises, and most are aware that some tax rises could make the problem worse if they drive business and enterprising people away from the UK. So we remain in a long pre-election period, when the public finances drift, and the problem gets worse. Whilst the fall in gilts has happened as we feared, we still do not think it right to buy them yet. The yields are better, but there is no shortage of supply in the months ahead. There’s no need to hurry whilst stocks last.

Reviewing "The Big Picture"

31/07/2009 00:00:00

Sometimes when undertaking Big Picture investing it is important to stand back and remind yourself of the story so far. Last year we recommended people be in cash. There was a nasty credit crunch underway, and it was likely to damage asset values. This year we said low interest rates would make cash a poorer investment, whilst after a year or so of ultra low interest rates there would be some kind of economic recovery. In the meantime, the advent of quantitative easing in both the UK and US would probably boost asset prices as people sought homes for all that liquidity, whilst worrying about government bonds. We also said that the Big Picture remained in our view the same as the last decade - Asia and some emerging markets elsewhere would grow much faster than the US or Europe. Equity investing is about investing in growth and rising income, so it seemed to make sense to orient portfolios heavily towards Asia. So far this year it has been possible to make good money in Asian equities, whilst seeing recovery in US and Europe after a further nasty slide in the first couple of months of 2009. There are now signs of monetary throttling back in China, whilst India is somewhat overheated. Commodities have rallied strongly from low levels on the back of Chinese stocking and easy money in the West moving speculatively and early into them. So what should you do now? Traders have taken some profit this week on China. This may present a buying opportunity for longer term investors, as the underlying story remains good. It does seem another good chance for a conventional portfolio to switch more money out of UK equities into Asian equity, as the UK market has performed well for several weeks. Sell the UK now, and buy Asian equity on dull days. There will be further bumps in the markets as people focus again on the need for the West to wean itself off quantitative easing. The big picture remains the same as before, only more so. Asian growth was far faster than US/UK and Europe in the decade to 2007. The gap will continue, as now the US and UK economies have to deal with the massive overhang of debt, both public and private, whilst shifting away from so much domestic consumption which sucks in imports. The bull case for UK equities over the last week as reported in the newspapers is based on the charts, not on any underlying reality from the dividend earning industrial or service sector. On the continent of Europe the strains and stresses of the Euro will become more pronounced in their impact on the peripheral economies. The demographic time bomb is also ticking, producing countries with ever more dependent pensioners to workers.

The pain of pensions

28/07/2009 00:00:00

Several UK companies are now large pension funds with businesses attached. The future of BA and the Royal Mail, to name but two, are dependent on how the pension fund issue is tackled. We are living through another round of pension fund closure, wind up and reduction of benefits. Any company which still has a fund open to new members is thinking of stopping that. Companies with funds closed to new members are asking whether they should now close their funds to new contributions from existing members. Some companies are in negotiation with members over possible reductions to benefits. Most funds are having to take some action to cut deficits. The total deficits of the main listed companies stand at £300 billion. Why have the deficits risen so much? Part of the reason is the poor investment performance of many funds which we described in Friday’s comment. Heavy reliance on UK and US equities to match or beat wage inflation has left the funds with disappointing investment returns. Part is the growing tendency for people to live longer, now reflected in more prudent actuarial tables, requiring more money to be put away to pay more pension to the same people. Part results from some pessimism about future price and wage inflation rates, which will also boost the cost to schemes. Members’ representatives and their advisers usually come up with one answer. The company should increase its contributions into the fund, and put in a lump sum to make up some of the shortfall. The company will argue back, saying that there is one thing more important than a well funded pension fund for members, and that is a solvent company capable of paying future contributions. A negotiation ensues to find a compromise which allows the company to meet all its commitments and tackle the deficit in the fund. The one thing all Trustees, members and advisers should be able to agree on is that better investment returns would help most of all. A company needs to rely on its pension fund earning similar returns to the returns it can earn on its business, otherwise diverting more money to the pension plan is counter productive. If the advisers insist on putting ever more in government bonds yielding 3% or 4% they are unlikely to achieve the future returns needed. Far from making the pension fund safer, it makes it weaker, and forces the company to put more and more money into a low return. There needs to be some commonsense around the table. Low yielding fixed income securities will not match growing pension liabilities. Nor have western equities at a time of stress in western economies done the job. It is going to take more intelligent asset allocation to get out of the deficit mire. The funds have to do some of the heavy lift. The companies need to keep some of their money to enhance their businesses. They cannot afford to fill all the pension black holes.

'Big Picture' investing

24/07/2009 00:00:00

More and more investors are looking at the returns they have made over the last five and ten years and discovering what poor times they have been for buyers of US, UK and European equities. Most conventional portfolios have been built around the cult of the western equity. Ten year returns on the main share markets have been around zero. Pension funds, charities, and wealthy families would have been better off staying with cash deposits or government bonds. Many spend substantial sums on active managers. Their claim is that they can beat the markets, and find returns even when times are hard or markets are heading south. Our research shows that there are a few managers who can invest in UK shares and beat the All Share, or invest in US shares and beat the S&P, but the overwhelming majority of active managers underperform over 3, 5 and 10 year periods. More importantly, even the few who do win, are not able to make up for the fact that the main share markets have done so much worse than cash, over 1 year and over 10 years, and time periods in between those two. That’s why we say you need to concentrate on Big Picture investing. The decisions which make the difference are over whether you should be invested in equities at all, or whether it makes sense to be in property or commodities or private equity. What money you do spend on advice should be on that. You cannot avoid having an asset allocation. Every day markets trade your asset allocation is tested by the markets. It can help having someone to watch over that for you. Big Picture investing can be long-term. If you want the prospect of good growth and do not mind volatility – investment management speak for losing money over shorter time periods – then you should have bought Asian equity over the last decade. We think the next decade could well prove similar. If it’s risk with the possibility of better rewards you want, then buy and hold Asian equity, where the growth is more likely. If you are more cautious, cash can be a good bet for some time periods. Today, given the low returns on cash, a portfolio of high quality corporate bonds may be attractive, and should generate you better returns than cash without all the risks of western equity. If something looks wrong, maybe it is. We think the huge sums the US and UK governments need to borrow will in due course place more strain on government bonds markets. If you agree, why hold these bonds?

Markets are more sanguine but the UK's problems remain

21/07/2009 00:00:00

The rally has continued in the major markets. More money is getting through to share markets, as the quantitative easing policies of the UK and the US continue to feed dollars and pounds into the system. Investors are relaxing about the state of the banks, taking some heart from better profit figures from a couple of the US investment banks. We remain concerned about the impact of ending quantitative easing, and the build up of such large US and UK government deficits. We regard this rally as a good opportunity to sell any remaining holdings of UK shares and bonds, as the adjustments that have to be made to the UK accounts will be large. The US position is a bit easier, as its banks are smaller in relation to GDP than the UK ones are in comparison to the host economy. The US also draws strength from issuing the world’s reserve currency. The US, however, has a large public deficit to tackle sometime, and US shares are no longer cheap on earnings multiple and dividend grounds. We still prefer the Asian markets, which have risen more from the lows against the background of much better prospective growth rates than the West allied to less obvious problems in their banking systems. The figures emerging in the UK show a big loss of revenue from property, income and sales taxes as the recession bites. They also show a rapid increase in unemployment, and therefore in the number of people on benefits. The government now accepts that spending will need to be constrained after the General Election, likely to be in May 2010, but is doing nothing to rein it in beforehand. The large issues of welfare reform, public sector pensions reform and the size of government remain largely untouched. The apparent stability of the UK system rests upon the requirement on the banks to hold more short dated government paper, on the closure of pension funds who in turn are buying more gilts, and on the Bank of England’s large buying programme of government paper. The Bank may add another £25 billion to its purchases at a future Monetary Policy meeting, but we must be getting towards the end of their programme. The commercial banks will probably hit their targets for more liquidity required by the Regulator quite soon, leaving just the pension funds as the main natural buyer of government bonds. This could put more upward pressure on interest rates for government borrowing. Meanwhile, the need for the banks to hold more government bonds reduces the amount they can afford to lend to the private sector. The measures needed to cut the deficit, coming on top of the rush of the private sector to cut its indebtedness, will mean a slower growth rate once the recession does lift. The excesses of the last decade will take time to work off, at a cost to the general economy.

Things are not all they seem

17/07/2009 00:00:00

Markets rallied this week. Investors took cheer from signs of better growth in China, and from bumper profits at Goldman Sachs. The stories ran that the world economy is going to get a boost from Asia, and Western banks can now make some money again. It all goes to show what wonderful things low interest rates and easy money are. The Chinese stimulus package has apparently produced quick results, unlike the packages elsewhere. The Chinese have certainly been able to stimulate their banks much more than the West, with Chinese money growth now accelerating dramatically. We need to be somewhat careful of the official figures for GDP growth, in an economy still very dependent on export earnings at a time of weak international trade. The figures may be overstating the reality on the ground, where many are laid off or on short time working owing to weak export markets. The Chinese can get their banks to react more quickly thanks to the degree of state control and the absence of a sub-prime crisis. Money is now pouring into shares and property, driving prices higher. It is going to take longer to stimulate internal demand sufficiently to make up for the loss of export orders, but there will be some favourable momentum even in the real economy from easy money. The good results from Goldmans do not mean the US banking crisis is over or the problem solved. The many state interventions allow banks to write profitable business today, and to pick and choose which business they want. It does not mean that all the past problems of the major banks are resolved or that we have seen the last of the write offs. Goldmans and JP Morgan are not representative of US banks. We should expect some more bad news before the banking crisis is over. The big imbalances in the world economy are going to take time to sort out. It is true that the weakened dollar and sterling will help adjust the big balance of payments deficits of the US and UK, but more by limiting imports. China will gradually increase internal demand more and save less, but she is still very geared to her old export-oriented model of success. Amidst all the uncertainties, one thing does seem to be clear. Asia is going to grow faster than the US and UK in the years ahead, just as it did in the last decade. More people are coming round to our view that there will be a permanent diminution in the UK growth rate during the years of sorting out the debt overhang. All this continues to point to placing much more emphasis on Asian equities than is traditional in UK portfolios. The pension deficits in the UK are also something to worry about. More companies will close their funds to existing members as well as to new members, and explore other ways to cut the liabilities. The poor performance of many of the portfolios in recent years has added to the gloom created by liability inflation. These will be another set of claims on the UK which will prove difficult to pay for or to sort out. The least bad asset class for mature funds appears to be the high grade corporate bond.

The western crisis is deep and long

14/07/2009 00:00:00

As the summer doldrums drag on in the markets, more people are asking serious questions about the US and UK recovery. The two governments have hurled everything at the problem, belatedly. They have printed money, buying government bonds. They have swelled the public deficits, announced new spending programmes. They have devalued their currencies. By the end of this year, when we come up to the anniversary of the deep interest rate cuts of 2008, we should see some end to the economic collapse. Some of the figures will start to look better, if only because they will be comparisons with dire figures from a year earlier. Lower currency levels allied to restrained demand will have some favourable impact on balance of payments deficits. There are limits to how much destocking companies can do. Despite this, markets are more inclined to ask the difficult questions. How do they get away from quantitative easing? How do they start to curb the massive public deficits? How can we expect much of a consumer recovery, when unemployment is still rising and cuts in earnings are commonplace? In the last few days the UK market has been uneasy partly because the Bank of England is experimenting with the idea that maybe it will not commit to more quantitative easing than the £125 billion announced. Naturally market participants are concerned that government bond prices will have to fall and their yields rise to fund the massive government deficit. The US market has been adjusting to the slow pace of recovery in the US economy, and realising that the Obama effect and his stimulus package have not had an immediate and positive impact in the way people hoped. Discussion of a second package has not helped. It has reaffirmed the view that the first one is not working, and reminded investors of the high price of the first package and its impact on the deficit. The problem with stimulus packages is they may not stimulate. If they are paid for out of taxes, some part of the increase in activity is offset by the spending forgone by those paying the taxes. If the package is paid for out of borrowing, there is always the danger that the market will remember borrowing is tax deferred, and will put up interest rates to allow for the extra borrowing. A well judged and popular stimulus package can help, but the law of diminishing returns can set in in conditions where a government is very highly borrowed and where it lacks credibility. So what should investors do? They should wait patiently if they are in cash and corporate bonds. They should cut their risks to western equity and to UK government debt, and look for opportunities to go east. The Asian economies are better placed than the west. The US and UK may not be in a similar position to Japan circa 1992, but the twin deficits leave plenty of risk on the table.

To ease or not to ease, that is the question.

10/07/2009 00:00:00

Markets have been drifting downwards as we feared. Some investors are going on holiday, whilst those who remain are worried about the slow response in the major economies to the large stimuli applied by governments. In the UK the big issue is how the government gets out of quantitative easing. This week the Bank of England’s Monetary Policy Committee met, kept interest rates down at 0.5% and said nothing about a possible increase in quantitative easing. They have spent most of the £125 billion they announced. They have the option of spending another £25 billion under their permission from the government. They could also go back to the Chancellor and ask to do some more, on top of the permitted £150 billion. Prior to the meeting many market participants expected the MPC to say they were going to spend the remaining £25 billion. They probably came to this conclusion because money growth is currently slowing down a bit, and bank credit is still tight for the private sector. The MPC decided to say nothing firm, leaving their options open. There may be divided opinions on the MPC about the issue. There will be general doubt about whether it is working and how much it takes. They will now be able to see how markets respond to a slower rate of spend and to the possibility of no more easing, without having burned their boats. The Governor thinks the purpose of quantitative easing is to create some more money. That has occurred, although it was also happening prior to the start of the bond buying programme. What also seems to have been happening is a switch of new bank lending from advances to the private sector, to paying for the government’s deficit and bond purchases. Where the government buys the bonds from the UK private sector, that frees some cash for the private sector to spend or to buy other assets like shares. If the purchasing is from foreigners, it may do the same, or it may lead to weaker sterling if the foreign gilt owner sells the currency as well as the bond. The government may be relaxed about that, as devaluation appears to be part of the strategy to try to curb the balance of payments deficit. We characterised the strong second quarter rally in shares and commodities worldwide as the quantitative easing rally. The money created on both sides of the Atlantic found its way into these markets, which has helped lift confidence a bit. Markets now need more evidence of improvements in the underlying economies, otherwise the higher prices of shares and commodities will look unsustainable. There is some evidence of more activity and better forward looking orders in Asia, but the outlook remains weak in the US and poor in Europe. The large imbalances in the world economy remain difficult to handle. We need much more progress on sorting out the trade deficits and surpluses between east and west, which is happening through a mixture of a big decline in western demand and some devaluation. We need to see how the US and UK will wean themselves off colossal budget deficits and quantitative easing. The US and UK are creating new large imbalances to try to deal with past ones. We have taken a more cautious stance for clients in the third quarter after the rally. We have not gone fully liquid, as we believe the authorities will do some more easing and spending if they fail to see any strengthening of the small and vulnerable green shoots.

The summer doldrums

07/07/2009 00:00:00

We are into the summer doldrums. As we expected, investors are asking themselves what happens when the quantitative easing money runs out? Commodity speculators are taking some money out of markets, aware of how far ahead of events in the real economy commodity markets have moved. We should expect share investors in the advanced economies to also start to query the delay in recovery in turnover and profits.In the UK the British Chamber of Commerce survey this morning contains the good news that confidence levels have risen sharply from the lows of recent quarters. It would be unwise to break open champagne, as we still cannot afford the imports.The survey also shows that “almost all the key balances remain in negative territory, and most balances are still weak by historical standards”. The net balance for home sales for manufacturing did rise by 18 points, but it is still at a heavily negative minus 37%. Worse still, the balance for manufacturers’ home orders, what matters for future turnover, rose 15 points to rest at an equally heavily negative minus 37%.Businesses need to generate cash to survive, and to have money to invest in the future. One of the worst figures in the survey was the one for manufacturing cashflow. At minus 32% it is at “the lowest level since records are available”. This survey shows that prospects and confidence levels have moved from dire to very worrying. After a long period of sharp downturn figures start to look better by comparison to very weak figures. That is not the same as a strong recovery. The BCC are saying that unemployment goes on rising, hitting future demand. They report what their members see, which is too few orders and too little cash coming into their businesses. It is good they also report what their members feel, and they are feeling a bit more optimistic. We need that optimism to translate into more orders.We remain negative about UK shares and government bonds. The UK has not done enough to sort out the massive imbalances in its economy. The banks are still weakened by the credit crunch, and at some point the UK will have to reduce public spending. The Bank of England may decide to use the remaining £25 billion of possible quantitative easing to keep the show going for a bit longer, but markets are now looking through that to ask what happens when the markets have to supply all the government borrowing they want unaided by artificial stimulus.

A new regulatory system?

03/07/2009 00:00:00

We can be sure of one thing. On both sides of the Atlantic the architects of the current failed system of regulation will conclude we need more regulation in the future. They will be interested in what they can add to an edifice which worked badly, not thinking about what they should demolish before rebuilding. In the UK we should expect two things. They will wish to strengthen the tripartite system rather than replace it. Instead of transferring FSA powers over banks to the Bank of England, and giving the Bank a unified command over bank supervision and the money markets they use, both the Bank and the FSA will be given bigger roles in regulating banks. There is unlikely to be a Glass Steagall law requiring the separation of investment banking from clearing bank activities. The authorities rightly understand that some of the weakest banks in the last crisis were either traditional mortgage banks like Northern Rock, or specialist investment banks like Lehmans. The large conglomerate banks got sucked in to the crisis at a later stage. Instead they think they will increase the capital and cash requirements of both investment banking and traditional banking activities, probably being tougher on the former. This will limit the capacity of any large bank to do more of both and force choices about priorities to use the capital. It will also mean slower growth for the economy, and more difficulty in getting out of the slump, as it constrains bank balance sheet growth and therefore limits the amount of money in circulation. The regulatory policy is currently pushing against the monetary easing policy announced. They will continue to devote a lot of effort to micro regulation – seeking to regulate each transaction and customer relationship – as well as putting more emphasis on high level or system regulation. Before and during the crisis the authorities had the powers necessary to demand more cash and capital but failed to do so. It was not a lack of power, but a lack of judgement which led them to permit the excessive build up of debt and books of financial instruments which characterised the period 2003-7. We need to ask will they be any better next time round? The issue is do the regulators have a leader or top officials with both the judgement and the confidence to use that judgement to control bank balance sheets sensibly? It does not require more people or new armies of number crunchers. You can do it by just examining the balance sheets of the top half a dozen UK based large banks. Any annual reading of those between 2000 and 2007 should have told the informed reader that leverage was getting out of control. In say 2005 the regulators should have asked banks to raise more capital, keep more cash, or rein in their lending levels. Today the regulators should not be raising their demands for cash and capital immediately. They should give the banks time to adjust their balance sheets, sort out their past bad debts and get their costs under control. The central Bank should be prepared to act as lender of last resort to ensure all the main banks have access to cash should they need it. The time to demand more cash and capital will come when we see money growth and bank balance sheet growth spurting ahead again. Instead of hiring a new army of regulators and inventing a new sequence of regulations, we just need one or two people at the top of the system with judgement and confidence. They already have quite enough power to do the job. The worry is the West will hinder its recovery with too much inappropriate regulation, leaving the field more open for eastern competitors. We should also expect continued policy lurches, as the authorities have still not restored normality to interest rates, money markets or banking.

UK assets remain disadvantaged

30/06/2009 00:00:00

The UK government's programme announced yesterday is all part of a political strategy. It is not underpinned by new budgets to try to control and then reduce the burgeoning public sector deficits. There will be a great deal of heat but little light shone by the political exchanges over the weeks ahead. The government will assert that the difference between themselves and their main opponents is they will invest in public services and avoid cuts, whislt their Conservative Opposition will introduce 10% cuts in departmental budgets other than education and health. The Opposition will say that is not their plan, but will say they on taking power will have to make some reductions to start the process of reducing the deficit. In turn they will allege that on Labour's own plans for public spending there will need to be substantial real cuts outside health and education programmes. So what is the truth behind this bitter exchange of soundbites? Public spending is very high and expanding rapidly, partly owing to the recession and partly owing to policy choices of the current government. Everyone acepts that spending has to rise when more people are out of work, as a natural stabiliser, but there is a difference over how much extra spending governments should undertake when public finances are stretched. We read this week that the cost of welfare budgets now for the first time exceeds all the revenue from Income Tax. The government has decided to avoid a Public Spending review and publication of new public spending targets for after 2010. It presumably wishes to avoid publishing figures which show reductions in programmes after the Election, and is clearly not in a position to publish figures showing continuing increases. The Opposition is prepared to say reductions need to be made, but is confining its detailed work to identifying a few obvious programmes like ID cards, health computerisation and regional government where it would save money by cancellation or reduction. In practise any government is going to have to cut the deficit. The longer action is delayed the more difficult it is going to be. So far the government has been able to finance it, as it has embarked on a large programme of quantitative easing, and has engineered substantial buying of gilts by pension funds and banks. Action in curbing borrowing and spending may well be delayed until after May 2010, the likely date of the General Election. The longer things drift, the more likely that markets will become concerned about the large imbalances. We advise investors to avoid UK assets in the meantime. The current rally in shares and sterling provides another opporutntiy to switch to faster growing and better fiananced parts of the world. We belong to the camp who thinks the longer term rate of growth of the UK is going to be lower than the past trend of 2.5% and the Treasury's official view of 2.75%. In the last decade the growth rate was flattered by heavy borrowing in both the private and public sectors. It is not going to be possible to extend borrowing on the same scale in the years ahead. Meanwhile, the main issue for markets from here is how the US and UK authorities move from quantitative easing to more normal monetary policies, and how far the ECB goes with more assistance to damaged banks. We think we have seen the best of the quantitative easing boost to markets. We are left with the twin realities that western banks are still damaged and recovery in the industrial economy is so far poor or non existent.

How to end extraordinary policies

26/06/2009 00:00:00

Markets need to know more about how the major economies are going to end printing money and curb their large public deficits. This week on both sides of the Atlantic there were hints that the current programmes of quantitative easing - printing money - will be the end of it. Both the Fed’s statement and the Governor of the Bank of England implied that the existing sums pledged will be enough in their view. In the UK the Governor also attacked the government’s public spending and tax plans. “We are confronted with a situation where the scale of the deficits is truly extraordinary. This reflects the scale of the global downturn, but it also reflects the fact that we came into this crisis with fiscal policy on a path which wasn’t sustainable and a correction was needed”, he said. The Governor is proving to be a shrewder politician than he has been a central banker. He may have misread the cycle badly, allowing too much money in 2003-6 and too little in 2007-8, but he is reading the political cycle well. He may have kept interest rates too low in the early years of this decade, and pushed them too high thereafter, but he now wants some sea room between himself and Gordon Brown’s tripartite regulatory regime. He understands the forces that now are pushing us to lower public spending after the next Election, and realises that the special measures taken to ensure the sale of enough gilts this year may not be possible again thereafter. He is siding with the Chancellor and the Leader of the Opposition against the Prime Minister, and is even daring to criticise the PM for the size of the deficit he built up as Chancellor in the “good times” before the crash. The Governor revealed this week that the Bank was not properly consulted on changes to the regulatory regime for banks, and has sent his warning shot about the deficit. We need a unified command at the Bank, capable of regulating the main banks, handling the government debt issue and organising the money markets as the Bank did before the 1997 policy changes. In the short term it will be more of the same – strengthened powers for the FSA to control banks, resulting in demands for them to buy more gilts and hold more liquidity. Share and commodity markets have run up rapidly in the second quarter of 2009 on the back of easy money and low interest rates. We have been expecting a pause and some reconsideration of prospects. If it is the case that we are near the end of the UK’s quantitative easing, and the US programme is not going to be expanded, then we would expect the doubts in the both the UK and US to set in more. Neither government has a clear plan on how to return from mega deficits to more normal public finances. Both face the task of selling ever larger quantities of government debt. That will mean higher interest rates. The ECB is attempting to loosen its banking and money markets, responding later to the recessionary pressures than the UK and US authorities have done. Manufacturing remains very short of orders, despite the big destocking which has occurred. The latest OECD forecasts may prove too pessimistic, as they have revised down their growth figures further for most economies. We continue to favour Asia more than Western share markets, and will invest more of the cash we have accumulated for clients in recent weeks when we see suitably priced opportunities.

Is inflation still a problem?

23/06/2009 00:00:00

Early in 2008 when interest rates were too high for comfort and likely to help bring more banks down, I called for much lower rates. At the time I said inflation would tumble anyway, as the inevitable recession bit. As expected the recession came, inflation has fallen sharply on the RPI measure, less so on the CPI measure. It is time to reassess the inflationary outlook, as interest rates have now been held well below normal recession levels for some months, and quantitative easing is well underway. UK inflation has proved to be more obstinate on the CPI measure than the deep recession would suggest, for three main reasons. The first is the collapse of the pound in 2008. As I warned at the time, a money policy which lurched towards being too easy would drive the pound down, which would leave us very exposed to imported inflation. We are now living with the consequences. Forward currency cover is running out for importers. Stocks of cheaper imports are running out. New product is costing more. The second reason is the commodity price revival, brought on by Chinese restocking and probably by speculative activity on the back of quantitative easing, Oil has more than doubled from its bottom levels earlier this year. Although sterling in recent weeks has been getting stronger, abating the import price issues, commodity prices have been going up more quickly than the currency, leaving more price pressures in the system. The third reason is the behaviour of some industrial companies. Usually in recession as volumes fall away companies offer price cuts to try to induce more spending on their goods, or at least to encourage gains of market share. This time round the volume reductions have been so enormous – a halving of demand is typical in the automotive areas for example – that some companies are taking a different view on price. They are saying to their customers our overheads per unit of output have risen sharply, thanks to the big drop in your orders. As a result we cannot afford to offer you any price cuts. In some cases they may even propose price increases, to try to reduce the losses on the limited output they can sell. In both the US and the UK industrial work forces are on the whole co-operating with management to combat the huge falls in demand. In many cases employees have volunteered for more short time working, extended factory holidays and the like to cut both output and their pay in the hope that will enable them to keep their jobs for the upturn. In other cases Unions and employees have reluctantly accepted the need for substantial redundancies and factory closures, as companies desperately try to cut their costs and output as demand plunges. Employees seem to understand that the banks are not prepared to pay for ballooning stock and work in progress that cannot be sold, and not prepared to pay for large losses in industrial customer companies. They have their own losses to finance instead. Companies have to run down their stocks of raw materials and finished goods, and have to cut employee costs. Most companies embarking on such reductions are also cutting out management jobs as well. Where the cuts are made by short time working, managers may also have to go onto shorter weeks for less pay. UK inflation will be higher than it should be owing to monetary and fiscal looseness, the commodity surge and the weakness of the pound last year. The authorities must not ignore inflation. It is down for the moment, but not necessarily out.

Government bonds are still unattractive

19/06/2009 00:00:00

May’s public borrowing figures for the UK should not have come as such a shock to commentators. Borrowing £19.9 billion in just one month is the kind of figure you would expect in current circumstances, with a government forecast of £175 billion additional borrowing for the year. Spending is rising by a massive 7.4%. Benefit and other recession related costs are rising quickly, but the government is also keen to spend more on a variety of programmes this year. Meanwhile revenues are badly affected by the recession. Corporation Tax is down by 27%, with worse to come as the lucrative financial sector companies report lower profits or heavy losses. Each bond issue is now an event, as the government steps up the amount it sells, and as markets watch to see if there is any suggestion that the government cannot sell the necessary bonds. This week was fine, but so it should be. Quantitative easing is still in full swing, so the government continues to buy bonds from the market at the same time as selling new bonds to the market. This allows the market to absorb the new bonds readily, whilst often making a profit on switching. Yields are also higher, making the bonds a bit more attractive. We remain pessimistic about UK government bonds – and US ones – for three main reasons. The first is Quantitative easing has to end sometime. It will be more difficult for the government to go on selling bonds in the right quantities at low interest rates once it is no longer buying in its own bonds. The second is that even after recent bond yield rises, the yields are still not that attractive for a long term investor. Lending to government at around 4% is clearly better than at around 3%, but it is still a low long term rate of interest compared to achievable past returns on long term funds. It offers little protection against future inflation. The third are the continuing huge deficits the US and UK governments are running. As the UK figures show, things are still deteriorating in the public finances. There is as yet no credible plan to curb these super deficits, other than hoping for a strong enough recovery to take care of the collapsing revenues and the rising costs. As unemployment is still going up and is likely to for some time, cyclical costs will still rise. The UK government has not shown any will to curb other expenditures this year, and declines a new public spending review to put detail on its stated intention to stop the growth in public spending after a General Election. £175 billion is only an estimate, and is the gap between two very large and fast changing numbers. In the UK it is true that the banks themselves will have to buy more government paper to comply with enhanced liquidity requirements, and true that some pension funds will step up their purchases as they receive bigger payments to correct deficits. Pension funds can also look more positively at higher grade commercial bonds, where the yields are much more rewarding. Quantitative easing is still in full swing, so money is still finding its way into riskier assets. We remain negative about government bonds, concerned at the impact correcting the large deficits will have on both US and UK growth rates, and even a bit more cautious now than at lower price levels about our preferred risk assets elsewhere.

Second thoughts make investors hesitate

16/06/2009 00:00:00

Markets have had a few second thoughts, as they realise the real economies are not recovering as quickly or as well as hoped. There are some green shoots, as the money from quantitative easing finds its way into riskier assets. Yet underneath the occasional favourable figure there remains falling output and restricted credit in many sectors.Commodities have rushed up on speculative moves and some Chinese restocking ahead of any upturn in use. Rates of decline may have reduced, as the most violent part of the stock cycle passes. The stronger US banks have repaid money they took in the US government bail outs. There is a palpable air of relief that no major bank in the US or UK is now thought to be in immediate trouble.We have been thinking about the longer term reality of slower growth in both the US and UK, the continuing problems within the Euro zone, and the impact of the need to repay more debt in the West. On the continent of Europe there remain worries about some bad loans and banking assets, as there has been less open discussion. The Baltic republics are under great strain. The Euro itself is making life very difficult for countries that have not controlled their costs and are now less competitive at the common currency rate. Meanwhile, even Germany remains in recession, thanks to the slower pace of cutting interest rates and the tighter monetary policy being followed. The UK and US have had shallower downturns than the big exporting nations so far, and have taken more monetary action to try to bring recessions to an end earlier. However, both the US and UK have in the process expanded their public deficits dramatically, and have large balance of payments deficits as well. Both are allowing currency depreciation to help price their companies back into world markets. Both will need to take action sometime to rein in their public spending levels before the debt levels impose too much strain on bond markets. Both have seen bond rates rise despite substantial quantitative easing. We have allowed cash levels to rise a bit to reflect the sharp increase in share values and the new air of hesitation in markets. It is going to take some better news on recovery to help the monetary easing fuel another substantial move ahead.

UK property through the worst but credit and tenant pressures remain

12/06/2009 00:00:00

I have been a pessimist about UK commercial and residential property. Values of commercial property have been falling for months. Commercial rents are weak. There is a substantial overhang of space. Retailers have gone bankrupt, leaving empty shops. Considerable new space is being completed in the City when tenant demand is weak. Businesses under pressure find it difficult to meet rising rent demands, and are often looking to reduce their floor space as an economy measure. There are some brighter spots, and there are some buyers about seeking to find bargains now there has been a sharp fall. Residential prices have also fallen, though less dramatically than commercial prices. Some estate agents now say there is a shortage of supply, and think prices might now stabilise or even rise from here. Normally it takes rising real incomes, stronger mortgage provision and an end to rising unemployment to provide good upward momentum to house prices, but these are unusual times. There are two arguments the bulls put forward that are worth examining. The first applies mainly to central London. The apparent fall in sterling prices can be doubled for an investor coming in with one of the stronger foreign currencies. To the overseas buyer London property looks a lot cheaper than it does to sterling based buyers who live here. There are cash buyers around who have always fancied a smart London base who think now is a good time to take advantage of the apparently cheap prices in their currencies. The second consideration applies more widely. The supply of homes onto the market is very limited. Many people do not think they could sell their property for a decent price, expecting the market to be poor. Trading up is being delayed by people worried about their job prospects or expecting lower prices for the bigger home if they leave it for a bit. You might expect more distressed sales. With interest rates very low more people can manage the mortgage. More institutions so far are seeing through customers with temporary difficulties. This could change for the worse as unemployment climbs. We have probably seen the biggest part of the falls in both commercial and residential property. There will be some who buy at a discount to current prices where there are distressed sellers or properties with potential and take advantage of current lower levels to find longer-term value. We need to remember, however, that the existence of some foreign buyers for London property and the existence of some hotter spots within commercial property does not overnight solve the difficult credit conditions, the falling rents and the poor outlook for tenant demand. If the economy grows more slowly this decade as we fear, and if there is less credit around, we have to adjust to a different level of property values overall relative to incomes.

Inflation outlook distorted by Quantitative Easing

09/06/2009 00:00:00

Markets are becoming very distorted by the quantitative easing policies being pursued by the US and UK authorities. Money is spilling in to the equity and commodity markets, as investors seek better returns than they get on cash and short-term government bonds. It is not rushing into longer-term government bonds as the authorities hope. Instead longer-term interest rates are rising and bond prices falling. Investors are driving commodity prices higher, and then using this as an argument to worry about inflation. If inflation resumes, they reason, the authorities will have to put interest rates up. Industrial output may remain low, the exports from China, Japan and Germany constrained, yet speculative demand anticipating recovery can still propel metals and oil higher. The underlying reality is somewhat different from the speculative money go round. Both the US and the UK governments have to sell large quantities of bonds over the next couple of years. At some point they have to stop buying their own bonds by printing money. That is why we have been negative on government bonds for some time. The longer-term growth rates of both the US and the UK are likely to be lower than the past decade. Both economies need to spend less and borrow less, which will lower the growth rates achieved. That in turn makes controlling the public deficits more difficult and more painful. If we are to avoid anaemic growth or the W shaped recovery some pundits now expect, the running has to be taken up by China and India, by Germany and Japan. Germany seems reluctant to spend, borrow and print more, preferring exports to home consumption. Japan has stretched her public borrowing in the past, and has had limited success with quantitative easing. China tends to try to expand by putting in more infrastructure. She needs now to allow Chinese workers to earn more so they can buy more. India is already near capacity and quite inflation prone. On income grounds the US equity market is no longer cheap. The UK still faces a painful adjustment, which has been deferred by current policy. Present share values and commodity prices reflect easier money and low interest rates. We still prefer Asian to western equity, but think as the markets rise so do the risks that the recovery will disappoint. In Eastern Europe the position of the Baltic countries remains very strained. This is a problem both for the architects of the Euro and for the banks that have lent substantial sums there.

Less credit equals lower growth

05/06/2009 00:00:00

US and UK quantitative easing, and low interest rates in most parts of the world, are pushing up asset and commodity prices. It looks as if the downturns will be less severe in the countries which expand their money supply fastest and borrow more. The problem is, that one day they have to start controlling money growth again, and they have to start paying back all the debt. Both the US and the UK authorities are reluctant to tell us when they will stop their bond buying programmes. On both sides of the Atlantic government bond yields have risen and prices fallen despite the large government buying programmes. The Fed Chairman has started to talk about the need to curb the large public sector deficit. The Bank of England is more muted in its comments, and seems more preoccupied with output and activity than with anything else. We see this period of asset inflation or recovery from the lows on March as a temporary phase for the West. The deep seated imbalances remain to be corrected. The longer-term growth rates of the heavily borrowed countries must be impaired. There will no longer be the same turbo charger on growth from private sector credit creation, whilst sometime governments will need to rein in to start to correct their huge deficits. So far this year Asian markets have done better than the advanced country Stock Exchanges. We expect this pattern to continue, as more Western investors come to realise that there is more growth in the East, and come to see that their own representation in these markets is still very small. India has done especially well recently, reflecting the election outcome and the continuing strength of the economy. There is some need for the authorities to tighten policy a bit, which might induce some more caution by investors. Many funds in the UK still have well under 10% in Asia and emerging markets, with far larger positions in UK and US equities. Given the different outlooks, we think there is a case for having more in Asian and Emerging market equity than in the US and UK combined. In the 1960s and early 1970s many western investors had small positions in Japan, although it seemed obvious they were going to outgrow the West. Western investors only expanded their positions in Japan late in the day, in time for the bubble to burst in 1990. It would be a pity if western funds do the same with China, India and the other Asian tigers in this decade.

Look East for investment returns and stronger currencies

02/06/2009 00:00:00

The dollar is in freefall. The pound has strengthened against it in recent days, as have most other currencies. The pound is even managing to rise a bit against the Euro, as people come to examine the banking problems and slow growth overhanging Euroland more intently. It does not relieve all the inflationary pressures, however. The pound is still well down on its value a year ago, whilst commodity prices have been the main gainers from the money printing. Oil has more than doubled in a few weeks. Economic news suggests the savage destocking of the winter is over. Now manufacturers will have to make a bit more to keep pace with much reduced final demand. Asia looks likely to perform better than the West. The world’s major stockmarkets have risen well on the back of monetary easing and low interest rates. Investors want to take more risk. The Chinese have probably been buying more commodities, preferring real assets to ever bigger piles of US Treasury bonds. As usual, markets are moving well ahead of events in the real economies. The question of financing the large public deficits of the USA, UK, Spain other leading western borrowers overhangs markets. In the last few days the yield on the 10 year US bond has shot up to 3.78% - it was down to almost 2% in December 2008. Both the UK and the US are experiencing some increases in the costs of government borrowing for longer periods of time, despite the substantial programmes of bond buying which the authorities have embarked on to offset the issue of new debt. The going will get tougher form here, once quantitative easing comes to an end. We remain strongly of the view that investors should look to Asia rather than to the West for their principle equity investments. We will use this period of strength in markets, buoyed up by monetary easing, to switch more from West to East. The heavily borrowed countries will suffer slower growth and face difficulties raising the borrowings they need as monetary policy is tightened in due course. Sterling can benefit for a bit longer from dollar and Euro weakness. To correct the remaining large imbalances in the world economy the eastern currencies have to go up against the western ones, to reflect the greater competitiveness of Asian economies and to adjust the money flows.

All aboard for quantitative easing?

29/05/2009 00:00:00

The ride since March 9th this year has been a pleasant one for recent buyers of shares, and some relief for those who held on during the dark days of the winter. It just goes to show what quantitative easing can do to asset prices. In the middle of the week there were poor house price figures from the US, which the market chose to ignore, and better consumer confidence figures which the market liked. Clearly there is plenty of money around at the moment, and investors are worried about being left out of the upwards move. It’s not a very stable world underneath the action being taken by the US and the UK. The over extension of cash and credit in the Western economies was part of the problem that led to the crash. Extending more is only a temporary expedient. The rest of the problem was made up by the huge imbalances between the successful export economies of Japan, Germany and China on the one hand, and the big importers like the US and the UK on the other. To reach a more stable world we are going to need more exports from the borrowers, and more spending from the savers. We need China, Japan and Germany to import more, and we need the US, the UK, and Ireland amongst others, to spend less and borrow less. In the short-term money printing is going to encourage more of the same, with more spending and public borrowing in the West. The exporters still look to the USA as the importer of last resort to get them out of recession, whilst Western consumers hope the heady days of spending more are not cancelled but just a little delayed this year. It’s not all bad news. The big fall in the pound should cut imports and boost exports, helping to right the bloated balance of payments deficit. The US seems to be allowing some fall in the dollar, with something similar in mind. The recessions themselves in the US and UK, coupled with the shortage of credit, are leading to less private borrowing, and to more repayments of debt. Encouraging more saving is difficult given very low interest and savings rates. As the world economy slowly recovers from the dreadful shocks of the banking crash and the violent stock cycle we have just witnessed, any stirring anywhere in the world is welcome and will help activity and asset prices off the lows. There are two things we should worry about as we enjoy the upwards movement in equity prices. The first is how the US and UK authorities get themselves off quantitative easing. At some point they have to announce that their purchases of bonds are coming to an end. They may decide to run the shorter bonds they have bought to redemption, but there will still be quite an impact from the cessation of easy money purchases of bonds, against a background of large issues of new ones to fund the deficits. That is why we have been recommending selling out of gilts whilst the government is still buying. The second is the impact of the crash and of a probable slower long-term rate of growth in the heavily borrowed countries on equity values. Investors as they become more optimistic assume that prices will return to where they were at the previous peak, and then exceed them. Japan after 1990 shows this is not necessarily the pattern after a severe credit crunch. People evaluating US and UK shares have to understand that some value has been lost for the longer-term. Some companies and sectors are going to find it difficult to get back to the profit and dividend levels of before. That is why we favour more investment in faster growing economies where the prospects for higher earnings and dividends are clearer. Quantitative easing will boost share prices in the short-term, and will help economies turn the corner. It does not represent a permanent solution to the problems of heavy public deficits and too many imports which still remain for the US and UK. Working those out will change quite a lot.

To Index or not to Index. That is the question.

26/05/2009 00:00:00

After the roller coaster ride of the last eighteen months, many Trustees and investors are surveying the damage done to their funds. The latest improvement in share prices around the world has taken the worst off the losses, but has still left all too many funds well below their levels of a year ago. Worse still, active managers who had managed to stay in touch with indices in easier times, have often been blown off course by the enormous volatility of the last year. There were not just absolute losses as prices fell, but for some bad relative losses as well. I was an active manager of share portfolios once. I remember how difficult it was. I remember the emotional ups and downs. If you had just been through a period when your fund had been losing against the index, there was temptation to park it in neutral, to get it closer to the index you were trying to beat whilst you looked around for your confidence again. Some of the funds we have been asked to look at recently show signs of that process happening as a natural reaction to the crunch and crash. Some active managers are trying to hug the index more. Some are keen to get in line with the benchmark or the index their clients are using, to cut their business risk of deviating too far from it. If they do, it means the Trustees and investors are effectively left making the big calls that determine future performance. If a client says to a manager we will measure you against a 70% UK All Share 30% government gilt model fund, the cautious manager is likely to be around 70/30 in his asset allocation. If the client says he will monitor your UK equity portfolio against the FTSE 100 Index, the manager will be tempted to reproduce something like the FTSE 100 unless he is confident or has a performance cushion in the bank. The more an active manager gets close to the index he is trying to beat, the harder he may find his task. The active manager incurs costs the index does not have to pay. Only by taking a distinctive bet against the index which works can the active manager hope to earn his higher fee and give the client a reward for the extra cost and extra risk. Meanwhile it is clear from all the independent research that it is asset allocation which makes the dominant impact on a fund’s performance. You cannot pay extra pensions or charitable grants out of “relative performance” in a falling market. Too often the Trustees are left making the crucial decisions about model funds and asset exposure without specialist advice. Meanwhile the search for better outcomes from active management can prove elusive. There are some active managers out there who can beat the chosen index, but you only know after the event who they are. Finding them is not easy. Deciding whether to be in equities or gilts at all is still the most important decision to make, and one you cannot avoid.

UK debt burden may be even higher than reported

22/05/2009 00:00:00

We have repeatedly warned about the dangers of the UK debt build up, and have advised investors to stay out of gilts or to sell them whilst the Bank of England is still buying. Yesterday Standard and Poors issued a warning about the rapid build up of UK government debt, saying that it could well go to 100% of National Income and stay at that high level for some time. They might in due course remove the AAA rating as a result. It was in some sense quite a mild warning. We think UK state liabilities are much higher than the narrow definition of debt used in the S & P figures. If you add in off balance sheet debts, possible further losses on bank assets, and pensions liabilities, the figures soar well above the stock of borrowing narrowly defined. There is currently no credible plan in place to start to tame the deficit and to bring it down in a timely manner. There are some overall figures in the latest budget documents, based upon assumed resumption of some growth, and some greater spending discipline. Most commentators feel more needs to be done. The economic forecasts are still optimistic for the longer-term, and the debt build up is now rapid. One of the most important figures to watch will be the amounts spent on debt interest. We all know debt interest will increase rapidly, as a result of the large debt issue programme. The danger is that once quantitative easing stops, there could also be a further increase in interest costs, if interest rates have to go up to sell all the debt the government needs to place. The gross issue programme of £417 bn in 2008-10 means £12.5 bn of annual interest charges if they raise the money at an average 3%. If longer-term rates rise further under the weight of the issue programme then the debt interest costs themselves will rise even more rapidly. We think investors should take note of the warning from the Rating Agency, and the logic of compound arithmetic, which makes controlling costs and debt difficult at these levels of deficit. In the last few days markets have paused after a spirited rally. We think more money will go into shares from the combined effects of quantitative easing on both sides of the Atlantic in due course, to be followed sometime later by some evidence that the worst of the downturn is behind us in the leading economies.

Where next for the markets?

19/05/2009 00:00:00

Markets have continued to make strong advances. There is a general feeling that we have seen the worst of the decline. Investors who had built up large amounts of cash feel the need to commit some of it to markets to avoid losing out. More money is coming in. In the UK money is having to go into pension funds to tackle their deficits. The news background however remains poor. Dividend cuts, reduced profits and poor output figures proliferate. Some worry that this recession is by no means over. They fear that the poor state of the banks and the huge debt overhang in the USA and the UK mean difficulties in returning to good growth. The oil price has been especially strong. The oil futures market makes it profitable to buy and store oil, trading against that position. There are large quantities of oil stored in tanks and tankers around the world, as the price surges. It reminds us how much speculative demand there is for oil, and how the absence or presence of investment money makes such a difference to the price. There have been similar rises in some other commodities, well ahead of a revival in underlying demand. So we are left with the same dilemma, as investors. Is this just a very strong and persistent rally in an otherwise gloomy and deep slump? Or is this the beginnings of a new bull market, based on the new liquidity coming in to the system and on the fact that share and commodity prices had got far too low? In Asia the Indian elections produced a result the markets had not been expecting. The victory by the existing government, with more seats than anticipated, allowed the markets to move up dramatically. In China there is some evidence that the reflationary measures are beginning to work. The quantitative easing money in both the USA and the UK seems to be finding its way into equities. Investors are naturally nervous about the longer-term prospects for government bonds in both countries, given the large issues ahead. We have invested most of our discretionary client money in Asian and world equity, and added positions in commodities more recently. We are not chasing prices in these better conditions, but continue to recommend that clients take some risk when something is stirring in financial markets and when in due course lower interest rates and more money will have an impact on economies. We took some modest profits on European corporate bonds, as we became more nervous about the prospects for the Euro.

Do you need to own government bonds?

15/05/2009 00:00:00

These conditions are not easy for investors. No-one has been here before. Interest rates are at new lows. Government borrowing is at a new high. The world economy has just been knocked severely. The US and UK authorities are pursuing large programmes of “quantitative easing”. It’s at times like this that I find it best to look at the obvious. I try to keep it simple. It leads me to the conclusion that owning gilts is unlikely to enable you to pay the pensions, the charitable donations and the family bills in the years ahead. If you lend your money to the UK government today, you will receive the promise of income at somewhere between 0.75% and 4.5% a year, depending on how long you lend them the money for. These are low yields by historical standards. The income from these fixed income bonds does not grow. If you buy and hold them you will still be getting the same low rate of interest in two or three year’s time, when the investment world may look very different. Most of the bonds are currently selling above their par or repayment value. If you hold them until the government pays you back, you can be sure of a capital loss. If you want to sell them before they repay, you will make a capital loss if interest rates rise from here. Yesterday gilts rose. They rose because the Bank of England was gloomy about the economy. Indeed the Bank is now, for the first time for some time, more gloomy than many in the markets. The bank implied that it would keep short-term interest rates down for a long time. In its gloomy frame of mind it is likely to carry on buying gilts itself, keeping longer-term interest rates lower than they otherwise would be. That does not make me want to leap in and buy some. It is true that the Bank can try to force long-term yields down more - pushing bond prices up - by buying in more gilts at higher prices. However, the more it buys in under the Quantitative Easing programme, the more it has to sell back if and when it decides to reverse the policy. The Budget book told us that the government needs to sell £220 billion of gilts in 2009-10 as well as £21.6bn of Treasury Bills. Out of this it will repay £16.6 billion of maturing gilts and meet its large budget deficit. All this implies to me that at some stage interest rates, both long and short, have to go up again. Clever traders may be able to make some money from a further gilt-edged rally, selling gilts on good days to the Bank and buying them back on bad days from the Debt Management Office. There may be a further burst of enthusiasm for gilts based on deflation scares. For long-term funds I would just ask, how low do you think long-term interest rates can go against this background? And do you think 3% on your money is enough? Gilts are only a good deal if you think inflation is going to zero or below and staying there, and if you think the government can sell what it’s got to sell without damaging the prices. I think you are better off out of gilts whilst the government still is prepared to buy them.

How to manage a pension fund

12/05/2009 00:00:00

Many funds in the UK employ an Investment Consultant to advise the trustees on asset allocation. The Sponsoring Company too may appoint a Consultant, as they retain a vital interest in how well the fund does. The Trustees listen to the Consultant’s advice at periodic intervals and fix investment guidelines, appointing managers to implement the agreed strategy. This system can break down at times of stress, or in periods of great volatility. If Trustees met early in September in 2008, and then met again at the end of January 2009, they would have lost a fortune by staying fully invested in equities. The extent of the banking catastrophe might not have been clear to them early in September, but would have triggered defensive action by a sensible investment manager with discretion during the difficult last quarter of 2008. A fiduciary manager might have seen the problem in advance. The bitter experiences of 2008 and the first quarter of 2009 have left many Pension trustees worried by the extent of the losses. They naturally ask is there some better way of organising things. Some are now looking at Fiduciary Management. That means appointing an investment manager charged with the duty of keeping the asset allocation under continuous review. The Investment Consultant to the fund can assist in finding a suitable Fiduciary Manager. The aim is to keep costs under control by finding a manager who will not only implement the agreed strategy, but will keep the strategy under review. If the Fiduciary Manager thinks the asset allocation needs adjusting between meetings, he will either be given delegated powers to do so, or will contact a representative of the Trustees and say they need an urgent phone or email meeting to agree action for changed circumstances. The poor returns on advanced country equities for a decade and increase in volatility means trustees and managers have to work harder to earn the returns pension funds need. The ever wider range of financial instruments and asset classes adds to the strain on trustees, who find it difficult to keep up with all the products and opportunities. There is a strong case for choosing a Fiduciary manager capable of undertaking dynamic asset allocation - seeking to earn a suitable real rate of return with controlled risk. Just by chance, that’s what we offer at Evercore Pan-Asset! We were in cash last year, and are in riskier assets this year. We are enjoying the current ride in markets, but we know there are still major problems out there in the main economies, so we will not try to be too greedy.

QE and low rates raise the mood

08/05/2009 00:00:00

Moods are important. Many market participants have switched from the fear that gripped them in February, to greed. This spring they sense they can make money again by buying and holding shares. Suddenly the 10% in cash that looked prudent two months ago is burning a hole in their pockets. Nothing goes up in a straight line day after day, so we should expect interruptions to this new trend. There is still plenty of bad news about in the economies of the world. Equity markets may be on the mend, but manufacturing industry still wrestles with poor demand and more de-stocking. Banks may now be able to write profitable business. There is plenty to do by way of recapitalising themselves and the rest of business, earning fees for bond and share issues. The authorities around the world are allowing them to make trading and dealing profits in government bonds, by issuing a lot and by interventions in the markets. However, a number of important banks in the USA failed their stress tests and have to raise more capital, whilst RBS and Lloyds are likely to go on losing money. Loan experience is still deteriorating on past advances. There are record amounts of oil afloat and in stock, yet the oil price is rising. Property values and rents are still falling in the UK and the US, yet property shares are rallying. All this implies one thing. Quantitative easing and very low interest rates are beginning to have an impact on the prices of risk assets. As intended, low interest rates force investors to seek more income by taking more risk. As planned, printing money puts more money into financial institutions, who can then buy more financial assets. These markets are very managed and stage managed. The authorities are talking them up, because they realise there needs to be more confidence to stabilise and then turn round the economies. The future course of the markets will depend on how successful they can be in trying to talk the economies into life, and for how long they continue with easy money policies. For the time being they are going to print more and talk more. We will be watching carefully, as moving from quantitative easing and very low rates to a more normal situation is not going to be easy. If they try to do it too soon they will reverse the asset price rises. If they leave it too late they will allow a faster inflation. We are staying with the positions we built up at lower prices.

Heavy weather now, but sunshine later on

05/05/2009 00:00:00

World Stock markets are continuing upwards, despite the bad economic news. The harder it rains, the more the markets say it will be sunny soon. We are living through a period when the gap between what people are experiencing in the rest of the economy, and what the markets are thinking about valuations and the future is especially wide. So what is the good news that has led to the improvement in share prices? Markets no longer think the main banks will go under. They reckon enough has been done to stabilise them. If it hasn’t, they realise governments will come to their aid again. They think banks in this climate can now write profitable business for the future. They see the massive destocking underway as a sign that we are nearer a turn. Once companies have run out of stocks or think their stocks are low enough, they have to start making and buying again. There is plenty of cash around. Governments are seeing to that with their quantitative easing policies and their easy money policies. Many investors, often late in the day, built up their cash positions as the market crashed. Some now think they need to commit that money to shares before they rise out of reach. Many are disappointed with the returns on cash and looking for a better home for their savings and reserves. The headlines are very different to the mood. US GDP fell by 6.1% annualised in the first quarter. UK industrial output has hit a new low. House prices in the US and the UK keep on falling. Unemployment is rising. So which is right? The answer is, both can be. Markets always start to rise well before there is any visible sign of improvement in the real economy. Unemployment goes on rising well into the upturn. If you print enough money and keep interest rates low enough, there will be an increase in asset prices. We would just remind readers that an economy like the UK one will experience a slower trend rate of growth for years, as it combats the high borrowing levels and the large deficits. A possible economic recovery still leaves the deficit countries with large debts to pay off and large deficits to finance. We continue to favour investment in faster growing economies, and think commodities are attractive at these levels.

Commodities still look good for the long-term

01/05/2009 00:00:00

The financial and industrial worlds have diverged again in the last six weeks. The markets have rallied well. The industrialists remain gloomy, making some more people redundant here, putting factories onto three or four day working there, closing a factory here, mothballing one for a week or a month there. The change of mood was most marked on Wall Street this week. First quarter GDP figures came in lower than expected. The market rose for joy. Analysts found the silver lining in the dark clouds of falling output. Destocking had been stronger than expected. We are nearer to the point where industry receives some orders again from itself, to fulfil those new orders that remain. Soon they will have to order from their suppliers because their stocks are low. There are still many expensive mathematicians in the City. The new buzzword is the “second differential”. Markets rise because the rate of collapse is decelerating. This is too clever a way of looking at it. Markets are rising because investors have cash and think we must be somewhere near the worst. We last wrote about commodities at any length when oil was over $140 a barrel. It seems an age ago, but it is less than a year. We said then that oil over $140 a barrel was a sell. We thought energy and other commodities were overpriced. Prices had been inflated by speculative monies pouring into the markets. We argued that we thought the bulls were correct in one respect. The medium-term future would see strong continuing growth in China, India and other parts of Asia. As people grew richer in these countries they would burn more fuel in all the new machines and heating and cooling systems they acquired. They would eat more meat which in turn would mean the need for more grains. Industrial metal demand would be strong to feed the factories making the products. We thought the bulls were wrong in anticipating further price rises from last August levels, given the amount of speculation in the market. We did not expect to see the forecast $200 oil barrel any time soon. The collapse of banks, credit and some investment funds in the final quarter of 2008 and the first couple of months of 2009 brought many commodity prices down to earth with a bump. We have felt for a little while this adjustment was now largely over. The speculators have been squeezed out. We have been buying some investments in this area for clients as a modest diversification in the portfolios, managed on prudent lines through ETFs. We do not propose geared positions or positions based on borrowed money. The bullish arguments about the longer-term last year have not gone away. The US and Asian economies will recover. As they do they will need to buy more commodities to replenish stock pipelines and supply the production lines. Several commodities and oil are now selling at prices close to or below the economic cost of finding and exploiting new reserves. The last year has seen a lot of new capacity projects cancelled or delayed. We think there will be some more inflation in due course in a world where governments are so busy issuing debt and spending so much more than their incomes. In such a climate commodities are a possible additional investment.

Pandemic fears may create a buying opportunity

28/04/2009 00:00:00

Yesterday markets wobbled thanks to Mexican swine flu. It served as a reminder to active investors just how difficult it is getting a portfolio right, when random events like illness can make a difference to relative values. Airlines and hotels suffered, pharmaceutical stocks prospered. All hinges on whether this outbreak of flu escalates gravely, or whether as we hope it turns out to be a mild illness outside Mexico, as it has proved so far. Asset allocators are not immune to the impact of such events. What we do is cut out the specific stock risks and judgements compared to the economies as a whole. Why try to do two difficult things, either or both of which can go wrong, when you only need do one difficult thing? So far we do not see the flu outbreak as a reason to change our fundamental view of the world economies and markets. If fear and alarm grips markets again owing to the impact of flu on economic activity, we might take that as a buying opportunity to increase our clients’ equity positions. Were this epidemic to become a pandemic then of course it would do some additional economic damage on top of the credit crunch. It would delay recovery a little longer, and could intensify the depth of the recession. We are at that point in the cycle where business people and financial market people seem most divergent in their views. To many in business the economy is still in freefall. They cannot see an upturn in orders. They are fire fighting, planning the next round of cuts in staff and output, or looking yet again at which costs they can cut. Meanwhile in share markets investors see green shoots in the most unlikely places. They reckon the rate of decline is softening. They latch onto one month’s random figures for house prices or more mortgages. They listen favourably to government talking things up. Share prices rise, persuading more investors they must not miss the boat. It is a time to look at the underlying position, and to try some historical perspective. We are especially interested in investment in real assets with growing income. It is usually such investment which makes people and institutions decent returns. We ask ourselves has it usually been a good idea to lend to the UK government at 2% or 3%? The answer is “No”. So why take the risk? Have rents and capital values of UK properties stopped falling? Do we think the next move is likely to be up? The answer is “No”. We think it is still too early to go back to UK property investment. If UK shares were really on a yield of 4.8% that would be good value, but how many more dividend cuts will there be? Do Asian equities after last year’s big falls look good value? Of all the asset classes where growing income and growing assets are an important part of the case, we think they look the best placed.

Budget confirms a dismal outlook for the UK

24/04/2009 00:00:00

The UK budget confirmed our worst fears. Where it was more realistic, in the forecasts for growth and borrowing in 2009, the figures were poor. Where it is more optimistic, in its forecasts for growth and borrowing after 2011, it was unbelievable. Like many other commentators, we not think the UK will spurt back to growth above 3% and stay there. The central figures for borrowing in 2008-9 and 2009-10 were at the very bad end of market forecasts. Over the two years together the government has to borrow £417 billion gross. The following years will continue to see large increases in debt. Public spending in the last two years of the current Parliament remains on a strongly upward trend, to be followed by years of austerity under Labour plans with practically no growth at all. We do not see the case for investment in UK fixed income government bonds at current interest rates, unless the bond is bought for matching purposes and held to redemption. Whilst it is true that the banks will be made to buy a lot more short and medium dated government paper under new regulations, and whilst it is true the Bank of England itself will buy some more under its quantitative easing programme, the debt issuance is very large. At some point the Bank has to sell all those gilts it has bought under the QE programme back to the market, or the government has to issue replacement bonds. Inflation may fall further this year, but the RPI falls are very dependent on the one-off effect of much lower interest rates. Meanwhile the CPI remains well above target as the full effects of sterling weakness work through. The government itself will also raise more prices, as it is planning with the reintroduction of the fuel escalator. The large public deficit, the rising tide of public debt and the uncertain path for getting back to fiscal balance will act as a constraint on growth in the UK. Investors and companies will fear more tax increases, and will understand the cruel logic of compound arithmetic as more debt is issued and more interest falls due. The budget confirms our view that investors are better off investing in equities elsewhere, and confirms our view that government debt is no longer attractive. The tax increases on higher earners and upon higher rate contributions to pension funds make the UK a less attractive place for entrepreneurs and new businesses. A favourable regime for such activities which was in place with 10% gains tax and 40% income tax has been made much less competitive by the increase to 18% and 50%. There are now larger incentives for portfolio investors to make gains rather than drawing income, to the extent that tax law allows.

Few surprises to come from the Budget

21/04/2009 00:00:00

The UK budget has been well advertised in advance. Gone are the days of budget secrecy followed by the drama of the Chancellor’s presentation in the Commons. We receive some of the Budget in the Autumn Pre Budget Report. Now in the week before the budget, the jobs package, the housing package, the green cars initiative, the extra £10 billion of spending cuts and the other main runners for inclusion are briefed to the press. There may be the odd surprise tomorrow, but it is unlikely to be anything of a magnitude that will have much impact on the economic outcome. A £1 billion housing market package is hardly going to be decisive after all the billions already tipped into housing finance through the public sector programme and through the bail-outs of the mortgage banks. A few billion here and there to help jobs, green growth and the like are not going to have much impact. This is a £1,500 billion economy so the odd billion is small. The economy’s progress will be determined by three things. The first, the large cuts in interest rates announced in recent months, points to economic recovery by 2010. This will be reinforced by printing money, or underfunding the government’s spending. The second, the poor state of the banks, will hold back the recovery as it did in 1990s Japan. The more the government subsidise them to delay sorting out the problems, the longer it will take to have a strong recovery. The third, the state of the public finances might not give the boost the government imagines. The budget needs to persuade the markets that there is a way out of the very large deficits the Chancellor will have at last to recognise. He needs to convince us that they can be financed in the short-term at sensible interest rates, and will be controlled in the medium-term by some combination of lower spending and more tax revenue. If he cannot, then we face higher longer-term rates of interest early in the cycle. Quantitative easing is not having much impact on longer-term rates, and cannot continue indefinitely. The Chancellor will probably adopt his predecessor’s tactic of giving some of the following years’ budgets at the same time as 2009-10’s. We will probably hear plans to rein in wasteful spending more in later years, and plans to increase taxes more after April 2010. Given the likelihood of an election in May 2010 none of this will cut much ice. The Treasury will need to produce some more credible forecasts of economic output for both 2009 and 2010. We should expect them to say there will be slow growth in 2010 after a bigger drop in 2009 than they have so far admitted. The size of this drop will have a marked impact on the level of the public deficit, as the numbers are very sensitive to levels of output. If they admit to say a near 4% GNP decline in 2009, that will boost benefit spending and cut tax revenues substantially, driving the borrowing requirement higher. They are likely to go for a more modest forecast of GNP decline, hoping that the action taken to date will cushion the fall.The reality is slower growth for some years to come, once recovery does belatedly get underway. Four of the turbo chargers on the UK economy in the decade up to 2007 may no longer apply. The rapid growth of credit and the fast growth of property prices are unlikely to be repeated soon. The high level of inward migration is likely to reduce as a result of fewer jobs on offer and tougher immigration policies restricting numbers. The lead sector, banking and financial services, will not be able to sustain its own heady performance of recent years. Public spending will need to be restricted, after years of rapid growth.On the positive side there can be more growth in exports and import substitution on the back of a weaker pound and better control of wages and salaries. The UK needs to save, invest and export more, and spend, borrow and import less. The UK equity market will now face a UK headwind as a result of the slower domestic growth, but will otherwise respond to the global picture given the high proportion of UK larger companies that have substantial overseas and foreign currency exposure. We continue to favour faster-growing economies for our investments in shares and other real assets. We do not think this UK budget can produce a miracle cure for what is a deep-rooted set of domestic problems.

Asset allocation needs to involve commonsense

17/04/2009 00:00:00

The days of buy and hold are long gone. If you had bought and held UK or US equities over the last decade you would have made next to nothing. You were considerably better off in cash. Government bonds fared a bit better, but there have been long periods in the past when holding government securities was a mug’s game, with inflation eating away at their values and markets damaging their prices for long periods. Some Trustees and investors think making judgements about asset allocation is too difficult. They try to pretend the problem does not exist, or think if they put in place guidelines, ranges and rebalancing they will muddle through. Many of these approaches came unstuck in the very difficult conditions of last year. If you purchased equities every time they fell below your guidelines as their values fell, you just lost more money. The brutal truth is you cannot avoid making a decision about asset allocation. Every day, whether you are thinking about the portfolio or not, whether you have made a conscious decision or not, your portfolio’s assets stand or fall on the vagaries of volatile markets. That’s why we say let’s see how we can work together to reduce or manage these big risks. It is difficult. We do not pretend we can make all the calls correctly, any more than anyone else. That’s why we try to make it easier for ourselves and our clients. Our first advice is to keep it simple. The more complexity you introduce, the more costs you are likely to incur. You can be certain of the costs – they are always with you. You can be less certain that all the cost will generate the extra return you need to win as well as to pay the higher fees. The second is not to take risks you need not take. A few investment managers do make money over and above the general returns on the type of assets they are buying by superior stock selection. Most don’t. They lose you money, because it is very difficult forecasting which shares and which sectors will do better. So we say index your various equity portfolios, and keep the management and dealing costs low to give you a better return than the average active manager. The third is to know what you do not know. If something is difficult to understand, if you are not sure of your view, then don’t deal in that market or that asset. We follow over 30 different asset classes and markets, but we do not always have a strong view on each one. When in serious doubt we avoid them. We regard UK investments as very risky at the moment. Of course UK equities will go up if world markets continue to rise, but it seems to us there are less risky ways of buying into world economic recovery. The fourth is to try to avoid adopting a fashion late in the day when everyone is wearing it. If something looks too good to be true it probably is. If people are having to strain their intelligence to justify unheard of levels for prices or yields maybe it is time to take a profit and be thankful you’ve made some money. Finally, do not regard cash as an asset you should never hold in serious quantities in an investment portfolio. It should not go down in value, which can be a very reassuring property when the world is out of sorts. I do not know which horse will win the 3.30 at Newmarket, any more than you do. I am not trying to find the best-performing risky asset for 2009 and put heavy bets on it. I leave that to clever and better-paid investors. What I think charities, pension funds, and many savers need is advice on how to manage risks in volatile conditions, and how to try to earn a decent return. To do that you do need to follow markets, prices and values daily and to have some idea of sensible and feasible rates of return. My colleagues call that “Dynamic asset allocation”. I call it commonsense. In my case it is well tempered by knowing just how cruel and humbling markets can be to those who venture their money or their opinion.

UK property still vulnerable

14/04/2009 00:00:00

There has been a brave attempt to talk the markets up. Green shoots have been sighted in the residential and commercial property markets, in retail sales, and even in the rate of decline of manufacturing. After the promise of the big increase in money which should come from quantitative easing and from the large expansion of the UK public deficit should come some response in asset prices and in due course in activity. I fear the UK residential property market still needs to fall further. One month’s figures on one measure showed an increase. The other measures showed continuing decline. The three month and annual figures still point downwards. It is taking a long time, as it usually does, for house prices to adjust to the new reality. Mortgages will be scarcer. Valuers will be more cautious in their view of the worth of a property to be mortgaged. Banks will want bigger deposits. More people will be out of jobs or fearing the loss of their job, so there will be fewer seeking to buy. Today we learn there is an increase in the number of dearer properties coming onto the market as executives lose their well paid jobs. Although interest rates are very low, helping affordability, house prices were very high. People will be more cautious for the time being about committing to house prices many times their incomes. They will begin to fear the next move, when it eventually comes, will be to higher interest rates. You cannot get out of a crisis brought on by borrowing too much by seeking to trigger another round of over borrowing. If you try to inflate another bubble, which you may, it will just delay the necessary adjustment and may make it even more painful when that comes. UK consumers were lent too much money to buy both houses and cars. The sudden removal of much of that credit caused the crash in both markets. The government may be trying artificial stimulus, but with broken banks it will be difficult to get enough new money through in the form of mortgages and even car loans to sustain another boom in these. If it takes on to the government books too much of the responsibility for pumping things up again, the government’s own credit rating will suffer. The US may get away with reflating again. With the world’s reserve currency and with the strength and depth of the US economy it may succeed in printing enough and borrowing enough to turn the corner. When it does the Asian economies should benefit as well. That is why we continue to prefer selective equity investment in Asia/Pacific. We still recommend avoiding UK equity investment and regard UK gilts as expensive and high risk.

The MPC - What comes after the rate cuts?

09/04/2009 00:00:00

This month’s meeting of the Monetary Policy Committee would be a good opportunity to review their progress with the latest adventure in monetary policy, quantitative easing. Few think the MPC is going to cut interest rates. Most accept they will keep them at a very low level for the foreseeable future. All that implies people remain pretty gloomy about prospects for the real economy. One would assume as soon as recovery becomes apparent the interest rates will have to go up to start to contain the inflationary pressures which current easy money will then generate. Over the last month longer-term gilt edged rates have risen, despite the government’s purchase programme and the presumed intention to get the government’s borrowing rate down. It would be helpful if the MPC would provide the markets with more guidance about how much money they intend to create and spend on buying gilts. Is it £75 billion, or the full £150 billion they have permission to spend? Did the Governor’s warning note mean they might not create even the first full £75 billion? It would also be useful to know what level of interest rates for say 10, 20 and 40 year money they want. After all, it will be a rigged market for a bit, and they are the ones who can print enough and buy enough to move the rates. I would guess they will spend all the first £75 billion and then review again. It would also be helpful if they could provide some commentary in their next minutes of what they are trying to achieve with quantitative easing. Clearly it is not to hit an immediate inflation target, as they remain 60% over target on the latest figures. Is to hit some future inflation target? If so, why are they so sure we face declines in prices next year and the year after unless they print more money? Have they taken full account of the impact on prices of the lower pound, and of the aggressive pricing now being put through by branches of government and the nationalised industries?If the aim of quantitative easing is to create more deposits, to literally print more money, then can we know how much more they want? Money growth has been faster in recent months. How much faster do they want it to be, and how are they measuring it? If the aim is to achieve a given level of longer-term interest rates, let us know what they are. If it is to achieve a given level of corporate bond funding at a specified average interest rate, let us have some indication of what they are trying to do. Markets dislike uncertainty, but also move and thrive on it. It is not usually wise for authorities to look shifty or uncertain. We do need to know more of their intentions. We remain negative on UK prospects, whilst these uncertainties are sorted out. Meanwhile, in the real economy, industrial output is now down by more than 10% over the last year. We should expect more job losses and continuing problems in many sectors. Rental falls are now most marked in the West End as well as in the City. Dividend cuts are common. It is still not possible to form a considered view on what is the sustainable income level on UK shares, or to be precise about how much damage to the long-term trend rate of growth this Credit Crunch will do. What we can be more sure about is dividend paying capacity remains much impaired, and the medium-term growth outlook will be worse than in the credit turbo-charged days before 2007.

The post-G20 reality check...

07/04/2009 00:00:00

After the Lord Mayor’s show comes the clean up. Markets gave a good send off to the G20’s show of unity. It allowed the share price rally to continue. Buyers emerged, seeking some better income compared to cash. Investors took comfort in some small green shoots, noticing the rally in Baltic freight rates, in some commodity prices, and the statements from commentators that China and the USA could start to see recovery this year. Will this be sustained? There is no evidence of a sharp turnaround in world trade or in the major economies yet. The thawing of credit markets is not happening rapidly. The banks in trouble are now in receipt of government support in most places in the world, but that does make them robust and able to create deposits and loans on the scale required. The Irish budget today is likely to see both spending cuts and tax increases to try to right the large and growing deficit. This bubble economy, inflated by easy credit in the good years, has seen a sharp contraction in its housing and building sectors as the credit was switched off. The government has had to go to the aid of banks that are large in relation to the size of the sponsoring economy. The adoption of the Euro has meant wage cuts have been necessary to try to price Ireland back into world markets as devaluation is not an option for them. Meanwhile they face difficulties in selling to their main export market, the UK, thanks to the devaluation of the pound. This budget is interesting, as the UK will have a late budget on April 22nd. The UK like Ireland experienced an over inflated credit bubble, which manifested itself in very high house prices and an overextended banking sector. There are two schools of thought about the budget. Some believe the government needs to do more of the same, spending and borrowing more to try to increase demand. Others argue that course of action will do more damage to the national finances, running the risk of going beyond the market’s willingness to finance the deficit. Doing more in the public sector will mean bigger cutbacks in the private sector, as the private sector has to lend the money to the government or pay extra taxes to sustain the higher levels of public spending. It is unlikely the government will do much to try to correct the deficit this April, as the electoral timetable dictates otherwise. They will need to come up with some more credible figures than those supplied in the Pre Budget report last autumn. It is unlikely the economy will start to recover well in July this year as forecast, and likely the deficit will be much larger than advertised. Meanwhile Dunfermline has been added to the portfolio of weak banks, which now includes Northern Rock, Bradford and Bingley, RBS, Lloyds and HBOS. At Evercore Pan-Asset we remain concerned about the high level of financial risk in the UK public sector. We think the UK is in for a period of no growth followed by slower growth. The huge imbalances in the public accounts will need to be tackled at some point. This is likely to mean higher taxes as well as lower spending given the way the government approaches the issue. We recommend investors to use this period of quantitative easing to sell medium and longer dated fixed income gilts. We also continue to prefer Asian equities to UK ones, and recommend switching out of the UK. We still like corporate bonds for their higher income and some recovery prospects as credit markets improve. We favour Asian equity for the recovery and would buy more on any setback.

After the G20

03/04/2009 00:00:00

The G20 agenda was always going to be a bizarre mixture of items reflecting the very different perceptions and priorities of twenty different world governments, and of the other countries and international institutions in attendance. The leaders were unsure whether to spend more of their time on discussing how to get out of the present international economic downturn, or on trying to prevent something similar happening again. They were more willing to discuss greater regulation and higher borrowing in the future, than how much stimulus to apply to the present. The US and the UK were keenest to get others to spend and borrow more. No country was prepared to use the summit as a platform to offer tax cuts or spending increases above those already announced. Instead agreement was reached on putting more money into the IMF so they can lend more in turn to countries that get into serious financial difficulty. This was presented as a policy to help the developing world, but may need to be called on to support higher income countries that can also borrow too much and reach crisis point in bond and currency markets. Those who borrow too much will be able to borrow more on terms to be settled in the future. The French and Germans were keenest to clamp down on tax havens, hoping to drive business back from lower tax jurisdictions to higher tax countries like their own. They settled for a list of offenders with gradations of opprobrium to be heaped on places that dare to offer lower taxes with insufficient transparency. They were also keenest on more regulation in the future to try to stop run away banks. Whilst the structure of largely national regulation will be kept, there are suitable words about international co-ordination and tightening of efforts. It will only work if regulators suddenly become capable of reading the cycle and willing to demand more capital and cash when all is going well. They haven’t been able to see the need for this in the past. The myth of the summit was that all the leaders needed to agree and to do the same thing. What we want is for the countries involved to do very different things, for their own crises are different. Germany, Japan and China need to borrow and spend more, to import more, and to save and export less. The US, Spain, Ireland and the UK need to do the opposite. They need to export and save more, and to borrow and import less. Their solemn declaration that they will not pursue protectionist policies is unlikely to be followed in practise. Many countries are now trying to devalue their currencies to gain a competitive edge. Many countries are offering subsidy to their financial and industrial sectors. Some are even looking at ways of buying home produced goods at the expense of imports and examining tariff and non tariff barriers to foreign goods and services. What matters is the change being made to monetary policies throughout the world. These, and their currency impacts, scarcely get a mention but they will largely determine what happens next. There are signs that the massive sums being committed to banks and markets are beginning to have an impact on some asset prices and on commodity prices. It looks as if the authorities favour another bout of credit expansion and inflation, but they will not want to mention that in the communiqué. There have now been some useful gains in Asian equities. The rally in China started earlier this year, whilst other Asian markets have joined in vigorously in the general rally of the last couple of weeks. We remain more optimistic about Asian and emerging market equity than we do about shares in the UK and Europe, favouring these locations for substantial representation in any equity portfolio. The US is also now enjoying a rally, with some believing that the worst is over for the troubled banks. We also continue to support corporate bonds, which so far have not performed well this year but continue to offer attractive yields. It is difficult to see how markets can carry on raising the values of share capital, whilst continuing to regard much corporate debt as being at substantial risk of default. We expect US and UK government fixed income bonds to continue to benefit from purchases by the authorities themselves and from quantitative easing. However, they do not represent good long term value, so we advise our clients with any remaining holdings to switch out of them whilst yields are low by historical standards. We expect there to be some resurgence of inflation in due course. The UK will have more price rises to come from the lower level of sterling and its high import dependence, despite the obvious downward pressures on prices from lower demand. There will also be an upturn in commodity prices once recovery gets underway – indeed there has already been some rally from the lows well before any increase in underlying demand for commodities like oil and copper. We are currently considering adding some commodity investments to our longer term higher risk portfolios, to complement the positions in Asian equity.

Market Moves

31/03/2009 00:00:00

Yesterday equity markets took a dive again. Reality came back home, as President Obama intervened to dismiss the boss of GM, and warned the US motor industry that there would be no more easy terms bail outs. Whilst there is more money in circulation, as the governing authorities create and spend it, it takes time for it to have an impact on industrial output and world trade. The main economic numbers continue to look poor. The US, UK, Spanish and Irish property declines are not yet over. The industrial output of Japan, Germany and China remains weak, given the sharp decline in the demand for imports in the highly indebted countries. The large imbalances in the world economy between savers and borrowers, and between importers and exporters, remain to be corrected. From time to time these realities will hit market sentiment. There is little sign of any immediate rebound in world demand for vehicles or other manufactured products. However, there are some signs of corrections taking place. Savings – or private sector debt repayment rates – are picking up in the heavily borrowed countries. The decline in imports to those countries is a necessary part of the adjustment. The high savings and exporting countries are taking action to create more domestic demand, as they need to do. Returns on cash remain very low, as all the principal economies are now close to zero official interest rates, and several are embarking on quantitative easing. Some banks are working their way through the losses and the shortage of capital. In the UK Barclays has passed the Regulator’s new stress test without needing taxpayer money or even guarantees to do so. We remain cautious, but wishing to buy corporate bonds for yield and Asian equity for recovery on bad days. We continue to avoid the UK, as the high level of public borrowing and the extreme imbalances which need to be corrected make the risks higher than in more balanced economies. We are suspicious of government debt instruments in highly borrowed countries at current low interest rate levels, despite the government buying which could drive yields lower before the bubble bursts. Whilst cash gives very little return, so far this year it has continued to do better than global equity or property, because it does not go down. For longer term funds we are concerned about the resurgence of inflation in due course. In the UK the CPI rose by 3.2% in the latest annual figure, despite the sharp contraction and the collapse of many commodity prices. This reflects the lower level of sterling and the UK’s import dependence. Inflation should fall more this year, but as the recent sharp rally in commodity prices has reminded us, when there is global recovery there could be some big price increases in the basics. The UK – and the US – authorities will also have an incentive to allow some inflation, as they consider how to repay all that fixed income debt.

A good time to switch from UK equities

27/03/2009 00:00:00

The easy money rally continues apace. As we hoped, Asian equity has rallied strongly on the back of improved sentiment, spin and more dollars on Wall Street. There is a concerted effort to talk up the world economies in the run up to the G20, more Central Banks are adopting the policy of quantitative easing, and more investors are tiring of poor returns on cash. Risk appetites are increasing. We remain concerned about the state of the UK economy. The timely warning from the Governor of the Bank of England will scale down any fiscal stimulus the government may have been planning, and has reminded people in the government bond market of the wall of debt that faces them as the UK works its way through two years of borrowing in excess of 10% of National Income. The latest figures show the authorities on target to borrow more than £150 billion in 2008-9, with a planned large deficit again in 2009-10. Investors and markets need more information about how this or a future government will get the nation's finances back onto a more realistic footing. How much could be done by cutting spending? How much by asset sales? In a world of intense competition for jobs and capital how could taxes be increased without damaging the attractiveness of the UK as a service centre and manufacturing base? The options are narrowing, and any government will find itself facing tough choices. Any sensible analyst has to conclude that growth rates in the UK are likely to be much slower in the period 2008-2014 than they were in the period 2002-7 despite the big fall in the pound which will help competitiveness to some extent. Slower growth will come from less inward migration of people, from slower growth in banks and other financial institutions, from the continuing property uncertainties and from the drag of a much larger deficit-encumbered public sector. We regard the current rally in UK equities as a good opportunity to switch from them into more attractive asset classes. Once the world can see an upturn, on the back of the easy money and the more positive government approach, commodity prices may move up a little more. There has been a bounce from the very low levels of earlier this year, but the prices of many commodities are still below the levels needed to sustain growth in output. A growing world, once Asia Pacific resumes more normal growth rates, will require more commodities which in turn is likely to fuel some further price rises. Oil below $50 is good value in the longer term. Industrial metals and agricultural commodity prices are also much more realistic today than six months ago, when they were still puffed by large speculative positions.

Where does reflation leave Euroland?

24/03/2009 00:00:00

Markets liked the latest version of the troubled assets scheme launched by the US administration. The trillion dollar scheme seems large, it seeks to harness private capital to the task of buying up bad and dubious loans from the banks, and comes hard on the heels of attempts to talk up bank shares with more positive short-term trading news. There are investors with cash around, and they are looking for a home for their money when income on deposits has reduced to nearly nothing. The Asian markets bounced along with the sharp rally on Wall Street. This is what we would expect, as any recovery in the US economy will help trigger improvements elsewhere. The Asian economies remain more competitive and hungrier for growth, despite the battering their export industries have taken in recent months, and despite currency gyrations which have often pushed their currencies up. We still favour buying Asian equity for any rally and for future signs of recovery. The impact of more money from governments and the more positive news will be to take some asset prices higher. We still think better quality corporate bonds offer attractive yields and should at some stage join in the more positive mood. We need also to remember that the latest trillion dollar plan does not suddenly end all the fears and problems. The world is dividing once again into two main blocs of countries – the large borrowers and the successful exporters. They still have different problems whilst both are experiencing recessions based on the collapse of the credit based growth model of recent years. The heavily borrowed countries like Iceland, and some of the eastern Europeans are having to retrench and seek international financial assistance. The major borrowers like the UK, the US, Ireland, and Spain are still able to raise the money they need but they are stretching their national balance sheets as they strain to recreate demand based this time on public sector rather than private sector credit. The US and the UK are printing money to buy bonds to get their economic machines moving again. All these countries need to be careful not to create too big a government bond bubble, and not to so overstretch the national credit card that future financing of their deficit becomes too expensive or difficult. Meanwhile the saving and exporting countries are experiencing painful recessions as well, mainly owing to the collapse of demand for their products from the heavily borrowed countries, adversely affected by the collapse of credit. Their problems are in some ways easier to solve. They can afford to generate more demand at home to take up surplus capacity, and they will benefit from successful reflation of the borrowing countries with their exports. Euroland has its own special problems, caused by the creation of a single currency zone from a group of countries that had not fully converged before accepting the new currency. The Eurozone contains strong savers like Germany and big borrowers like Italy and Spain. The zone does not have the large transfer payments to the poorer or struggling areas that are common in older currency unions within a single country. The credit spreads on differing government debt have widened, as investors realise that there are no guarantees from Germany to the weaker countries running large deficits. There are concerns about the state of the Euroland banks who have committed large sums to Eastern Europe, and active discussion about if and how much assistance is going to be given to the East and to the banks. Meanwhile the ECB has taken less action than the Anglo Saxons to reflate demand despite the large fall in output.

Obama Administration bogged down by the Credit Crunch

20/03/2009 00:00:00

The Fed has now joined in the policy of printing money and buying up its own government bonds, to try to reassure investors that all is well with the world. Monetarists assure us that this will create more deposits in banks, which in turn might be spent and start to lift the recessions. That would be good news indeed. If you hurl enough money at a problem, someday some of it might start to do something useful depite the broken banks and the falling property prices. The monetarists are right to say people and companies are short of money. It's deposits that they need more than bank loans, turnover businesses require more than working capital bank facilities. My worry is that on both sides of the Atlantic the governments are trying this at the same time as running very large government deficits, and issuing huge quantities of bonds to pay for them. Markets are being told that buying different government bonds is a "flight to quality" which can never be criticised. Those who think this have not read their history books. History tells us that many countries have in the past defaulted on their public debts when the burden becomes too great. It's not just the well known South American villains who have let the international money lenders down. Countries like Spain, Japan and Germany have also been serial offenders if you go back far enough. The UK and the US have not in the past cancelled obligations or refused to pay interest, but they have often inflated their way out of the full rigour of the repayments, paying the lenders back in depreciated dollars or pounds. Even if this time round they do prevent a return of high inflation and meet all the repayments, it is still possible to lose money from a "flight to quality" if you buy a long bond on too low a rate of interest. There can be bubbles in gilt-edged securities, as well as in properties and private sector shares. One of the problems the Japanese encountered when trying money printing in the 1990s was deciding how quickly to withdraw the cash once it seemed to be working, to avoid triggering a great inflation. They also discovered that if you did not first mend the banks, it was difficult for anything else to work. It is worrying how quickly the Obama administration has been bogged down by the Credit Crunch. They try initiative after initiative, just like the UK, allowing nothing time to work through before doing something more. At the base of all this trouble is the failure of the authorities on both sides of the Ataltnic to take a tough approach to the broken banks and financial institutions where the public sector now has a significant investment. It is causing political pressures for the politicians, as some largely or wholly state owned banks and other financial institutions report high pay and bonuses, big losses and no great leap forward in lending. It is likely that all the money being spent on the problem will start to filter through to the real economy and to asset markets. In the short-term oil and shipping freight rates have rallied from their lows, and there has been a share rally including some of the banks’ shares on Wall Street. We continue to favour buying shares in the faster growing countries with stronger public finances. These should be in a better positon to benefit from global improvement when the lower interest rates, money expansion and banking policies start to have a favourable impact.

Are UK equities the natural asset for pension and charitable funds?

17/03/2009 00:00:00

Pension and charitable funds share some characteristics in common. They both need to pay future wages. Their liabilities rise in line with the wage index or even faster. The sponsors would like the funds to grow faster than wages, so they can do more, or so it costs less to provide a given amount of help. Normal advice proposes that these long term funds need to invest in assets with rising income. I have never agreed with the argument that buying a mixture of long bonds paying a fixed income can secure future pensions. The liabilities will go up, whilst the income from the long bonds will stay the same. That income in turn needs reinvesting, and the rate at which you can reinvest it becomes an important issue. The advantage of equity investment is that in normal times equities give you rising income. For many years equities beat government securities, both because their income was rising, and because as the income rose so the share prices and assets owned rose in value. It was sensible to conclude that the asset that most matched the requirements of a long-term pension fund or charitable fund was equity. In normal conditions the income on shares would rise by at least as much as wages, and sometimes by more. The last decade has not been a good one for this theory. Over the whole of the last decade investors in UK equities have now lost money, whilst holders of government securities have made money. Equity owners have not enjoyed their share of the growth in the economy, which performed well for most of the ten year period. We need to ask ourselves whether this simply makes equities cheap, or whether there has been some more important change. You would expect equities to grow over the long-term in line with growth in dividends and with the economy as a whole. Dividend and earnings growth may at times exceed overall economic growth if the share of profits in the economy as a whole is rising. They might underperform if the share is falling. The first thing we need to look at is the long-term growth rate of the economy. The UK economy grew faster than Euroland in the last ten years. It did so for a variety of reasons. These included a wider adoption of high leverage for banks, for property and for the general corporate sector. This use of high and rising leverage pushed apparent profits and activity levels up. The country experienced rapid inward migration of people willing to work flexibly, as the Eastern European countries joined the common labour market area of the EU. The UK was especially successful at attracting and retaining large amounts of financial sector business, which was itself pumped up by the excess credit being created. These three factors are going to change adversely in the years ahead. For some time we will be working on a model with less corporate gearing, which will lower profits and dividends in the better times. The financial sector has to slim down considerably, as the excess credit is washed out of the system. Whilst the UK may remain a relatively attractive destination for migrants, the big rise in unemployment and shortage of vacancies may act as a brake on that. In addition, the transfer of more activity from private to public sector tends to transfer resources to less productive and less efficient uses. There will be some offsetting trends that help. The current level of the pound, if it stabilises here, will offer exporters and import substitution businesses a better competitive edge. The temporary large expansion of government will offer some compensating demand for businesses. The bottom line is likely to be a lower trend rate of growth in the decade starting 1 January 2009 than we enjoyed in the decade just gone. This is not good news for equity investment. Added to this, it is quite possible with two large banks nationalised and more activity in the public sector, that the share of profits in the economy as a whole will fall. On historic yields of 5% the market is apparently cheap. If we could say that in a year or two’s time profits start rising again and dividends go up, this would be the steal of the century to buy equities on such high yields. However, it is very likely there will be substantial dividend cuts. The banking sector paid around one quarter of the total dividends paid out in 2007. Taken together the main banks cannot afford to pay any dividends. Some will do so, but they will seek the money from shareholders or other new investors in order to have the cash to pay out. The property and house building sectors will also need to husband cash. If oil stays around $40 a barrel or lower for any length of time the oil majors will have to go easy on the dividends. Many cyclical manufacturers are strapped for cash and low on profits at the moment. Most analysts agree there will have to be cuts of a third or more in dividend payments before this crisis is over. If we could be sure the cuts will not be more than say 50%, and that shortly afterwards growth will be resumed, equities still look reasonable value compared to gilts on 3%. However, if growth is going to be lower, and if the share of profits in the economy is going to be squeezed, it all puts a bit more pressure on equities. We still believe growing income is what pension funds and charities most need. We remain worried about the short-term prospects for dividends, as we cannot be sure how far they will have to fall, and about the growth rate thereafter. The UK economy at best is going to grow more slowly than in the last decade. At worst there could still be a nasty accident, given the high level of public borrowing and the state commitment to large and weak banks. We think faster growing income of a more reliable kind can be found elsewhere. We have been recommending investment in Pacific basin equities on bad days in these dangerous markets. There we expect the recovery when it comes to generate much faster growth than in the UK, which should in turn lead to faster growth in company profits and dividends.

Too big to bank?

13/03/2009 00:00:00

I have always been careful to go along with the conventional wisdom that there are banks that are too large to be allowed to fail. No sensible person wishes more carnage in markets, and few enjoyed the collapse of Lehmans. To concede that does not mean, however, that I have to support the huge sums of money the UK government has made available to bail out bad banks, and certainly does not mean I agree with buying shares in them which can delay sorting them out. If the authorities are foolish enough to get themselves into the position where some banks are too big to fail, it is even more important they take prompt action to break them up so they cease to be too big to fail.The correct strategy with an unwieldy conglomerate like RBS is to break it up into its constituent parts and find answers for each of them. Some could be sold immediately. Some will need managing to health and some like the Investment bank can be closed down after the bits of value have been sold. You should also keep RBS short of capital and cash to force it to raise more of its own, and to prevent it from paying the absurdly high salaries and bonuses it is still paying when it is no longer making profits and raising private money to do so.This is a good policy for the taxpayer, cutting the taxpayers risk and getting some cash back. It is a good policy for the banks’ customers, leading to more banks and therefore more choice in the marketplace. It is a good policy for the regulators, making it easier to see what is going on with each business having its own balance sheet and its own more visible and accountable management team.The dangers of the present UK policy is the easy access to taxpayer capital will delay the weak banks from owning up to the overriding need to cut costs, to cut out loss-making business, to recognise losses on their trading and investment portfolios and to get themselves quickly into a shape where they can sustain themselves again. We need less banking than we had, less gearing than we had, and fewer fancy financial instruments than we had. We need rather more bank facilities than are currently available, and more money circulating productively through the system. The Competition authorities were asleep on the watch in recent years. They should not have allowed the Lloyds/HBOS merger, nor some of the constituent mergers that created RBS. Allowing banks to become that big does damage the market, putting too much banking under common decision-making and ownership. The regulatory failure in the UK occurred thanks to the tripartite system created in 1997. Splitting responsibility for banks’ capital and solvency by making the Bank of England responsible for the banking system and making the FSA responsible for individual banks, left the Treasury in ultimate control to ensure there were no cracks between the regulators. Unfortunately there were. This system failed to see the obvious. Banks were allowed to expand their balance sheets far too much. It does not take more people to work that out. Just one person who knew what they were doing could have seen that the top four banks were all expanding too quickly and had too little capital in relation to the amount of business they were writing. If I could see that from the sidelines, surely the Chancellor could see it aided by all the advisers he enjoys at the Treasury, Bank and FSA? The authorities had the powers to make sure banks have more capital for any given volume of business and should have used them. In the summer of 2007 I wrote: “… there is considerable uncertainty about how far the Fed, the ECB and the Bank of England may go in raising rates to squeeze inflation out of the system. They must know there are huge pyramids of debt throughout the system, and inflation will not be killed unless the appetite for more debt is blunted. They also know that if they push interest rates too high for too long they could bring the debt structures crashing down, as we have seen with the sub- prime mortgage collapse in the USA, leading to falling asset prices, rising unemployment and even recession. “ Today we know they did not understand just how precarious the system had become. The MPC misjudged the length and severity of the squeeze they needed to administer. As a result we have banks that are badly weakened by the excesses prior to 2007 and by the tightening of 2007-8. We need to work our way through those difficulties as quickly as possible. Sterling and the prospects for UK markets rests to a considerable extent on how long it takes to sort the banks out and how much damage finally emerges from that process. Given the size of the banks, and given the degree of financial risk now resting with taxpayers, we remain of the view that there are better investment opportunities elsewhere. We continue to avoid UK equities.

Another grim week

10/03/2009 00:00:00

The last week has seen another sell off in worldwide equities, as investors have taken fright at the continuing gloom from the real economies. This year investors have become more nervous about the short term prospects of the stronger exporting economies. These have experienced even sharper declines in manufacturing output than the high-borrowing countries as their export efforts hit the high headwinds of collapsing world demand. Meanwhile, the importing and borrowing countries, led by the US and the UK, are taking time to respond to the lower interest rates and monetary activism unleashed belatedly by their authorities. We remain pessimistic about the UK. The superior growth rates to Euroland achieved in the last decade owed much to the success of the financial sector which is now troubled, to inward migration and to substantial expansion of public spending. Each of these favourable factors is going to be different in the years ahead, as the UK will at some stage have to control its public spending and borrowing, and as it becomes a less attractive place for migrants with fewer new jobs available. The UK authorities have now announced their asset insurance scheme for Lloyds Bank to complement the RBS scheme. The result will be that the government gains a majority shareholding in Lloyds, meaning that the government will own controlling stakes in a £2 trillion bank, RBS, and a £1 trillion bank, Lloyds. The future of the public finances, and the progress of the currency, will now be strongly linked to the finances of these large banks, which have a combined balance sheet twice UK GDP. As if on cue, sterling fell back below $1.40 and below 90p for a Euro as the Lloyds package was revealed. On both sides of the Atlantic governments are considering what additional support they can and should offer to the ailing motor industry. Worldwide there is huge overcapacity. Governments and customers are demanding quicker changes to model ranges to make vehicles more fuel efficient and cheaper to run, whilst people are reluctant to borrow to buy a new car when they are faced with uncertainty about their own jobs. In the EU eyes are turning eastwards. There is a growing realisation that several countries in the former Soviet bloc are in need of financial help. Some wish to join the Euro to try to stabilise their currencies. Others in the West already within the Euro are suffering badly from its current level, which is hitting their ability to export. There will be frantic talks to try to find a remedy for the Eastern countries. The struggling Euro members are likely to be told to deflate more to try to bring their costs down. We continue to recommend caution to investors. Cash has turned out to be the least worst of the major investment classes so far this year, despite the low returns. Some government bonds are also benefiting from the announcements of quantitative easing, to be carried out by governments buying in their own bonds. Whilst low yields and high prices in US and UK government bonds may have further to run in the short term, in the longer term the need for both governments to raise such large sums from the bond markets could change that position markedly.

Bear Market Blues

06/03/2009 00:00:00

A bear market is one where news is construed in a pessimistic direction and where the same news recycled causes further falls. This week has shown that is still happening. Yesterday Wall Street had another bad day. We were told the market was spooked by the auditors’ remarks on General Motors. Last year’s figures from that company showed it was in a dire financial position. The company sought taxpayer assistance last year. For weeks we have been told it needs more support. In the circumstances it would have been surprising if the auditors had given it a clean bill of health. Markets have been worried by banks not paying dividends or reporting further problems with their loan books. Again, this should not have been a surprise. It has hardly been a well kept secret that a number of western banks are in serious financial difficulty. Why would investors expect good dividend payments or stunning profit figures in the circumstances? In the UK the monetary authorities and government duly went to the next stage in their adoption of monetary easing. They took interest rates down another 50 basis points, and stated an intention to buy £75 billion of bonds from the private sector. Corporate bond prices moved little. Gilts did rise modestly. This news was potentially bullish for asset prices. It did not have a strong positive impact whilst the bad news did have a big impact on shares. In Euroland the ECB followed suit with a 50 basis point interest rate cut, as the Central Bank there surveyed the sharp decline in German economic activity, adding to the woes of the area where the peripheral economies have been in stress and strain for some time. Normally half point reductions in interest rates would themselves be both very newsworthy and positive for markets. The arrival of large additional buying power like the UK government bond buying programme would usually shift prices more strongly. Markets are being driven lower or held back by the growing disillusionment of a wide range of professional investors. Many of them have been trained in long bull markets, and are shocked that there can be such a savage decline in asset values. They see authorities in panic, trying a whole range of policy responses that have not been seen on this scale before, or even talked about at all. Suddenly, whatever the news or the state of the cycle, more of these investors want to hold more cash at the very point where the authorities take interest rates to virtually zero, undermining the returns on the last asset left standing. We look at sustainable income as one of the important questions for longer term investors to consider. If you can buy shares or property on high yields with the prospect of income growth you should do well, and in the meantime even if capital values decline you can pay the bills from that income. One of the problems at the moment with assets like UK equities is how far will dividend cuts go, and how long will cuts last, before we can tell what true income yield the market is on and look ahead to income growth again. On a historic yield of 6% the market looks very cheap, but in practice it is on a much lower yield when you take account of the lack of dividend paying power in big sectors like the banks. Property too is now on attractive yields, but only if we could see the end of rental declines. Property experts are moving from a more positive to a less positive attitude, seeing that the high rents of 2007 could fall substantially before this property bear market is over. We are still not recommending UK shares and property. We remain cautious, awaiting more signs that investors generally will start to look through this nasty recession to eventual recovery.

Why isn't it working?

03/03/2009 00:00:00

Markets looked as if they were beginning to form a base, to look through the gloom of the crisis. Some started to anticipate greater financial stability, and eventual economic recovery. The market chatter said that banks were now underpinned by government action. There would be no rerun of the “crisis” of last autumn and no more runs on major banks. Reflationary packages would help, and the magic of lower interest rates would gradually work through. It was after all a normal cycle, even if a rather violent one. Many investment houses remained fully invested throughout. In recent days old fears have returned to stalk the markets. They have been joined by some new worries. Central to the recent sell off has been the continuing weakness of leading banks. In the US dreadful figures from the nationalised mortgage bank were followed by worse figures from AIG and yet another rescue package for that unhappy insurer. In the UK RBS duly delivered dire figures. The government offered another huge financial injection to them. HSBC announced poor figures coupled with an enormous £12.5 billion rights issue. In Euroland there are growing rumours about large losses in Eastern Europe, producing stress for Austrian banks especially. Joy at the US, UK and Euroland reflationary packages has been tempered by asking who is going to buy all the government paper needed to pay for them. Hope based on the authorities’ talk of quantitative easing has been met with fears of inflationary consequences if they overdo it. Every possible piece of good news generates a contrary worry. In other words, it has remained a bear market. Pension and charity Trustees looking at the big losses recorded by many funds in 2008 are now realising that it has in many cases got a lot worse in the first two months of 2009. Some are concluding their funds are still running too much risk for the conditions. The authorities in the US and the UK are so visibly desperate to try everything that it makes building confidence difficult. In both countries government believes it needs to borrow more to tackle a crisis brought on by too much borrowing. In both the state readily pumps huge sums into distressed financial institutions that need to make fundamental changes to their costs and their business model in order to have a viable future. The easier the authorities make it for these businesses to get taxpayer money, the longer they delay making the necessary changes. The more the authorities borrow to put into the banks, the more they undermine confidence in public finances. The weak banks and insurers need to cut out loss-making business, reduce their investment banking and trading activities drastically, put remuneration onto a sustainable basis and cut their employee numbers. They need to work their way patiently and professionally through the books of past business which is difficult, and only write new business which is a good bet and which they can afford. It’s no way out of a credit explosion to lend more money to people and companies who will not be able to repay it. Markets are already beginning to discount the large bond sales programmes the authorities will need. Towards the end of last year we warned about the government bond bubble. Since then yields on longer dated UK and US government bonds have risen, as markets have started to reappraise the risks. If the authorities are too imprudent this fall in bond prices will continue, making it more difficult and dearer to raise all the money they need. Lower interest rates and quantitative easing normally work to end a slump and to initiate recovery. The authorities in the US and UK are making it more difficult, by forgetting the lags between lower rates and positive moves in the economy, and by damaging their own balance sheets to sure up the banks and other financial institutions. I am not advocating more bankruptcies on the Lehmans lines, but do think a period of tough love for the banks would work better, whilst protecting the credit rating of the state. This remains a bad time for the prudent and for savers. Damage limitation is still the best strategy, with the low returns on cash once again being about the best available from the main asset categories over the last month. We have remained cautious for discretionary clients.

Will the Euro survive?

27/02/2009 00:00:00

This week saw the launch of David Marsh’s book on the history of the Euro. It makes a timely opportunity to review the currency’s progress, and to explore its role in the Credit Crunch. In the UK much of the debate has been about whether the Euro will survive, with some of those hostile to UK membership extending their argument to suggest the Euro is too artificial a construct, a currency in search of a country. They have pointed to the lack of convergence of several of the Euroland economies with the German core of the system, forecasting the break up or at least the shrinking of the numbers of participants in the scheme. As someone who has always been against UK membership of the Euro for a variety of economic and political reasons, I have never shared a wish to disparage the new currency, nor to exaggerate the forces that may seem to pull it apart. I have always wanted success for the new currency of the UK’s neighbours, and felt that the absence of UK membership would assist its chances, as the UK economy is divergent from the Franco-German one. In this column as an independent commentator and analyst of the scene I am neutral over the political calls anyway. It is important to understand that the Euro is essentially a political project. As David Marsh makes clear, its origins are deep in Franco-German history, with both sides seeing a common currency as an important part of political union between them to make future conflicts impossible. To the Germans it was the ultimate gift to France to let them have the excellence of the Bundesbank transferred to a wider area. To the French it was a way of trying to have influence over the German economy. It developed from that to a wish to create a common currency area throughout much of the continent, as part of the longer term aspiration of a united Europe. If the economics get in the way, ways have to be found to get round the economics. Until recently it was unthinkable on the continent that the currency might be under severe pressure or fall apart. It was fortunate that the countries which most diverged from the centre, Greece, Spain, Portugal and Ireland, in the early days benefitted from lower interest rates than they needed, and from faster growth than they might otherwise have achieved. It was fortunate too that the economies that diverged most tended to be the smaller and more peripheral ones. The central core of France, Germany, the Low Countries and Austria had largely converged and anchored the system. Everyone knew there was huge political support for its maintenance, and an optimism abounded that a few years of some tensions and economic differences there would soon be a more harmonious converged whole. Today I detect continued strong political will power to keep the currency together and deal with the tensions. However, the Credit Crunch is now testing the mettle of the system, just as it is testing others. In one sense it is increasing the determination of the founders to keep the Euro. They see solidarity and strength in size. At the gates of Euroland there are suddenly small countries being badly buffeted by their own policies and world events, wanting to join to gain the protection of the large grouping and the transfer of responsibility for maintaining a currency. In another way the Credit Crunch is posing problems for the world of the Euro before its creators wanted to make some big decisions. There are two obvious signs of tension over support for banks, and the amount of debt a country can be allowed to run up in the common currency. Austria, and to some extent Germany, has extended substantial credit to Eastern Europe (€230bn, equal to 70% of Austria’s GDP). People are discussing whether the West needs to bail out the East, and if any of the liability is a pan-Euroland liability rather than the responsibility of the individual member states to support their own banks. In Austria’s case this could prove expensive. Countries like Italy, Greece and Spain have larger public debts growing at fast rates. Should they continue to borrow at low rates suitable for Euroland as a whole? Is this free-riding on the backs of the more prudent states? As markets gradually increase the cost for the less well managed economies, are they being unfair in penalising what remain Euro sovereign debts, or are they not adjusting enough in case the country leaves the area? The Germans are considering making payments or loans available to the harder-pressed states. The relatively high level of the Euro reached during 2008 is making it more difficult for the high borrowing weaker economies to adjust, worsening their balance of payments. There is a case to say that if you wish to have a flourishing single currency there has to be a mechanism to shift substantial funds from the more successful to less successful regions of the wider area. There also becomes a case for a larger central budget, with tax raising powers at the Union level. The EU has been keen to delay making such fundamental changes, knowing there would be substantial public opposition in some parts of the EU to this, and knowing that it is not just the UK government that would oppose such a centralised vision. The EU will be hoping that it can use the crisis to increase the powers of the centre somewhat, but get by without large transfers of cash to the weaker places. The pressure in on countries like Italy to cut their costs drastically to live with the relatively high Euro from their point of view. After all, Germany may argue, that was what Germany had to do at the start of the scheme. My cautious conclusion is that the Euro will survive this testing crisis, with all or most of its members intact. There will be strong pressures on the high spenders and borrowers to rein back. There will be periodic bouts of Euro weakness when markets worry about how feasible all this is. At base it remains a political project. Its creators will not necessarily be averse to strengthening the centre if that is what is takes to get through the crisis.

The Honeymoon is Over

24/02/2009 00:00:00

The US market has not responded well to the twin packages proposed by the new President. The honeymoon has been short-lived. The main problem with the President’s approach is the large extra borrowings he will need to raise to pay for it all. The bank and Insurance company rescue package is getting larger by the day. The decline in the economy is boosting the government deficit anyway as tax revenue falls and unemployment related spending rises. On top of this Mr Obama is adding “reflationary” measures. The combination has led to some rise in government bond yields as market participants work out just how much more government debt will be issued. It has rekindled longer term inflationary fears by some, and led to strong opposition from the Republicans who have condemned the big debt build up. Today the President is going to tell both the Senate and the Congress that he will return to the paths of financial rectitude before the end of his first term. He will need to back that up with substantial detail to make it persuasive. At the moment all the forces of events and policy are pointing in the opposite direction of more borrowing. The US is likely to put more capital into banks and AIG, as the new Administration is “stress testing” them all in a way that is likely to conclude some need more capital. The UK is pointed in the same direction. The losses of the nationalised banks have weighed in at £30 billion for last year. Taxpayers will be asked to forgo interest on the Preference shares put into Lloyds, just as surely as the government has converted the high yielding Prefs into something easier on the bank for RBS. The government is still unearthing more losses and difficulties in the troubled banks. The positions of the US and the UK are different. The US has the world’s reserve currency, with many creditor nations owning substantial quantities of US government debt. Whilst the US obligations to sort out their banks are large, they are not as large relative to the size of the economy as the UK banks are to the UK economy. It gives the US a bit more room for manoeuvre than the UK. We remain concerned about the UK. Government debt is about to treble on official figures, as some allowance is made for the liabilities of the banks now wholly or partially owned by the state. If you add in the pension obligations and other balance sheet items the figures are even larger. We still recommend avoiding UK equity investment. We see plenty of reason for caution. We continue to hold high quality corporate bonds, as a way of trying to improve the poor running returns on cash.

Travelling through the recession

20/02/2009 00:00:00

President Obama launched both his megabuck plans. One aims to reflate the economy by extra public spending and some tax cuts. The other builds on the Bush TARP proposals to buy distressed assets from banks to try to lift the gloom in the financial sector. The US Stock market was not impressed. The markets fell further because they are worried about the sharp acceleration in the downturn around the world, and concerned about the lack of detail in the banking package. The decline in the heavily indebted nations like the US and UK is now being matched by sharp declines in activity in the successful exporting nations like Germany and Japan, as they struggle to keep alive their export-led economies in conditions of poor demand worldwide. Indeed, on the figures so far the downturn in the US is less severe than in many other countries. In both the US and the UK the monetary authorities are talking about quantitative easing, more commonly known as printing money. The variant they both favour is the direct purchase of bonds held by the private sector, to inject more cash directly into the hands of those who previously held the bonds. Both now think inflation is over. In the case of the UK the targeted measure is still at 3%, well above the 2% target, and there is evidence of further price increases to come through on imported goods following the decline of the pound. The RPI in the UK is now almost zero, but this is flattered by the temporary VAT cut and especially by the big fall in mortgage interest rates. In both the US and the UK wage inflation is subsiding. Yields on corporate bonds remain well above the equivalent maturity government bonds in the main markets. We have bought some for clients, and are hoping for some reward in the form of revaluation. In the meantime there is a good yield compared to the income on offer elsewhere. We feel clients do need to take some risk this year as the return on cash is so low, and at some point the market will feel it has discounted financial pressures on the corporate sector sufficiently. We have bought some equity positions in the US and Asia, which so far are caught in the general world problems. We will be adding more to these on bad days as we travel through what should be the worst quarters of the recession. In due course the extra money being pumped into western economies will make a difference. Meanwhile the Eastern economies are taking some reflationary action of their own. In the case of China she can afford to, and needs to rely more on domestic demand and less on overseas demand for her future growth. We remain predominantly in cash and bonds for discretionary clients. The world is not going to recover without some turnaround in the USA. When things do get better we expect the Asian economies to continue their outperformance. We remain nervous of the UK, owing to the large public deficit. The Office of National Statistics published a preliminary finding that the bank share purchases would add £1 trillion to £1.5 trillion to national debt, or 70-100% of National Income. This is on top of a fast increase in the conventional debt to finance public spending. The Monetary Policy Committee of the Bank of England is seeking permission to undertake quantitative easing, whilst making nervous comments about the impact of lower sterling on prices. We think when it is time to buy equities and property more generally, it will be better to do it elsewhere given the special risks in the UK

Ethical investing is complicated

17/02/2009 00:00:00

In Cambridge last week I was asked about ethical investing by one of the Colleges. My experience tells me there are as many different views of ethical investing as there are institutions wishing to do it. The two most common types come from people who want to make a statement against war and weaponry, who wish to keep their portfolios free of arms companies, and those who are concerned about health and wish to discourage cigarette smoking. As an individual I have a lot of sympathy with both. I do not smoke, and think diplomacy and discussion is a better way of sorting out disputes than resorting to killing. If a client wishes to avoid certain investments then it is always possible to do that by one means or another. However, on further analysis it turns out to be very difficult to do it effectively. Let us take the case of weaponry. Is the manufacturer of the weapons the main cause of the problem, or the many governments who wish to buy them? You could argue cogently that investing in UK or US government debt is unethical because they both spend such large sums on weapons, and sometimes use them to invade other countries. If they did not do it, the companies would not make the weapons to their order. Any individual weapons buyer and any individual weapons maker will usually argue that these items are for necessary defence. If you take either case, where does the ethical investor stop? Is it just the tobacco company that makes the cigarettes? Should it include the banker than provides the capital to that company, the advertising agency that helps them promote them, the cleaning company that cleans their offices and the engineering company that supplies the machinery? Is it just the main weapons maker, or is the component suppliers that feed their factories, the finance company that helps the government arrange the borrowings to buy them and the legal firm who draws up the contracts? It is of course possible to run ethical portfolios both using active management and passive management. ETFs allow you to concentrate investment on more moral areas like green energy, water, infrastructure, and on world markets where weaponry is not an important item. An active investor can leave out any named sectors or shares. We are happy to handle client monies as they wish, but recommend not putting some ethical limit on the investment task. Our main reason is that the world is more complex than simply leaving out a few shares. The world economy is now very integrated. It takes thousands of people and many different companies and skills to deliver a tank or a cigarette to its end user. I keep my politics quite separate from my investing, and find it makes more sense to do it that way.

"We will do whatever it takes to turn the Economy around"

13/02/2009 00:00:00

In the last few weeks there have been two important developments in markets. Shortly after we here, alerted you to the growing bubble in the prices of UK and US government bonds, the markets generally started to worry about the huge debt issuance programmes both governments are planning. The yields on longer dated bonds have risen, the prices of the bonds falling, as investors started to make some allowance for the sharp deterioration of government deficits on both sides of the Atlantic. At the same time, markets moved from liking the idea of stimulatory packages to get economies going again, to expressing more scepticism, with further January falls in equity market prices. There was to be no first month market honeymoon for the new President, despite the upbeat rhetoric of “Yes we can”, the promise of millions of new jobs, and the gritty realism of the post victory economic analysis. I think it helps to understand what is going on to remember that government are spending huge sums of money on two different problems. They are spending huge sums on buying new capital in banks, helping banks write down damaged assets and lending them money to keep them going. At the same time they are increasing government spending programmes and cutting taxes to try to stimulate more activity directly in the non banking sector. Their supporters tell us both are necessary. They make the reasonable point that if they do not help mend the banks, the decline in the rest of the economy can get worse. If there are few car and home loans, and restricted working capital and investment loans for business, the general outlook will continue to deteriorate. If they do not stimulate demand by creating more jobs and spending on more projects, there may well be further declines in the value of loans on their books. The problem is that trying to do both is very expensive. President Obama thought he could unite the nation around colossal state spending on both causes. The Republicans have dug in, opposing the magnitude of the spending, and the detail of the reflationary package. Opponents argue that more government spending means less private spending. In the first instance money has to be saved and put into government bonds, and later taxes have to be higher to pay for it all. What is the point, they ask, of switching spending from private to public? They also remind the government that the crisis hit because the US – and the UK – was spending too much and borrowing too much, sucking in too many imports. At some point the imbalances have to be corrected. You do not solve a crisis of too much borrowing by borrowing more, they argue. Both the US and the UK authorities seem to be moving to policies of creating more money through quantitative easing, buying more bonds and increasing the Central bank’s balance sheet. This should filter through to asset prices and to activity levels in due course. The monetary decisions matter more than the reflationary packages. The decisions on general reflation and banking support are expensive and just mean a bit more inflation when the economies do come out of the downturn, and mean higher taxes for longer when the bills have to be paid. We continue to recommend good quality corporate bonds and selective equity market buying where investors have high cash positions.

A Tale of Two Banks

10/02/2009 00:00:00

On both sides of the Atlantic we are waiting for the next plans to save the banks and reflate the economies. The US market has rallied a little in expectation of agreement on the Obama reflationary package, as the Senate debates the balance between tax cuts and spending increases, and its overall magnitude. In addition the money markets actions are beginning to have some effect. In the UK we are awaiting the detail on the revised banking package, to see how much insurance is going to be offered for bad loans held by banks, and what it will cost. Meanwhile the Fed, the Bank of England and the Treasuries are thinking about whether to ease the money supply further through a variety of techniques, including underfunding of deficits, direct purchases of treasury bonds and injecting more cash into the banking system through money market operations generally. There has been some easing in credit markets as a result of the actions taken so far. The authorities both sides of the Atlantic are committing large sums to the tasks of assisting the banks and reflating the economy. There have been differences of view on how to do it, but each side has now been influenced by the other - or by similar ideas – to the point where there are common strands to the actions. The US has injected some new capital into banks; the UK is now looking at purchasing or underwriting bad assets. The US did nationalise a couple of mortgage banks, as did the UK. The only difference has been the UK’s decision to take a substantial stake in RBS as well. This difference could turn out to be important, as it has placed a large sum of taxpayers money at risk in the UK and posed big management questions for the government over how far should it intervene and what should it try to do with its large bank? The publication of Barclays results in the UK highlighted the contrast between their performance in 2008 and that of RBS. Barclays announced a profit of £6.1 billion, with write offs at a manageable level, where RBS is suggesting total write offs and losses of £28 billion. This leads people to ask how two large UK registered global banks could end up with such a different performance. There are three possible explanations. The first is that RBS was badly managed, complicated by their decisions to acquire a large number of overseas assets near the top of the market, whilst Barclays has been better managed. The second is that RBS’s new management have decided to take a very pessimistic view of their banks assets at the beginning of their regime, to make recovery easier. I would hope that auditors and the government as owners would ensure the figures are realistic and in line with current understanding of potential bank losses, so this rules the latter explanation out. The third theoretical possibility is that Barclays will find more losses later. I rule this out, as I am sure the Directors and auditors will have crawled all over the figures, well aware of the need for prudence in these conditions. The most likely explanation is that RBS was less well managed, and took on too much in its acquisitions which have cost its shareholders dear. It remains surprising that the government did not undertake proper investigations of their likely 2008 results before finalising the purchase of the shares. I remain to be convinced that things were so desperate they needed to finalise everything in a single week-end. It subsequently took a long time to get round to buying the shares and putting the money in, time which could have been used for due diligence followed by changing the terms of the deal in the light of the discoveries. That would have protected the taxpayer interest more. As Barclays points out in their 2008 results, it was the Regulator’s demand for higher capital requirements at such a sensitive time which has led to Barclays not paying a dividend. That call to increase the demands at that worst of all possible times was the background to the panic share buying by the government. It did not help the banks re-establish confidence, and it left the taxpayer stranded with some shares which soon dropped in price. Could it work from here? Yes it could. That will depend less on the reflationary package of the President, and more on the actions of the main world authorities in money and bond markets. On both sides of the Atlantic there have been signs of second thoughts in bond markets about just how much governments need to raise, with some fall in Treasury bond prices. It should urge western governments to greater caution in their spending, so they do not try the patience of the markets too far and cause long term interest rates to rise too much.

Some Home Truths about the Credit Crunch

06/02/2009 00:00:00

Many policy makers and commentators are looking for a magic bullet, a single package, a measure which will solve the crisis. They will look in vain. We need to remember that the UK crises - and the US one - were born of over borrowing. Collectively British people and their government spent too much and earned too little. Collectively they borrowed huge sums from banks and from abroad, to pay for large quantities of imports. Now it is the time of reckoning. You cannot solve a crisis of borrowing too much by borrowing more. The UK private sector needs more cash - more earnings, more turnover - more than it needs more borrowing. The UK government, borrowing too much when we were apparently doing well, now wishes to borrow unheard of amounts. That just delays the full reckoning a little, and means much higher taxes in the years ahead when the bonds have to be paid back. The banks, too, were mightily over-borrowed and over-lent. You cannot solve a crisis of too many bad loans in private sector banks by simply transferring the loans or the risk on them to the public sector. In the case of the UK, the banks taken together are too large for the state to bail out comprehensively. Giving them new capital or subsidy merely delays the need to sort out their risky assets, trim back their commitments, cut their costs, and start making some proper profits. Whenever people propose things that sound crazy because they say we need radical and new measures to tackle the problems of the time you should ask why the normal laws of arithmetic, and commonsense, have been suspended. Why does it suddenly make sense for the state to take on the debts of the banks? How can the state run them better? Why should taxpayers pay for the mistakes? Let’s take the idea of a Bad bank which is surfacing again. In a way the UK already owns three or four bad banks - it has, after all, taken control of RBS, Northern Rock and the assets of Bradford and Bingley, and has a large stake in HBOS. These are bad banks in the sense that they are all coming forward with large write offs or trading losses, and have all needed injections of government capital. These are so large that they stretch the state’s capacity to fund them. Why should we want to create yet another bad bank to take on the difficult assets of the other banks in the system, when those banks seem capable of sustaining themselves in the private sector? There has to be some limit to how much the state takes on, before its own ability to raise money is damaged and it has to pay a higher rate of interest in order to borrow through issuing bonds. The truth is the banks have to work their way through their positions, reducing the scale of their risks in the most sensible way possible. This may need management change in the case of the banks that are losing large amounts. It does not need nationalisation to do it. Indeed, nationalisation may delay such a necessary process, as politicians would want the banks to do more than just sort themselves out and slim themselves down. How do you sort things out? The banks should close down their overextended positions in financial instruments as opportunity presents. They should net out positions that can be netted out, to de-gear the overall system. Where they have non-performing loans extended to private companies, they should consider debt for equity swaps or delays to interest payments where they think there is a viable long term business that can one day repay with suitable penalties. There is no quick fix. Swelling the public deficit too much just creates another problem of too much borrowing, which will become a crisis or a major problem at some point in the future. We need some good bankers who can patiently work through the bad debts, doubtful loans and huge positions which their banks have taken. The state should be the lender of last resort, making sure no major bank goes under. It should not be the funder of first choice, subsidising bad practise, bonuses and overextended banking. If a bank needs short-term state lending it should get it, but on terms which protect the taxpayer and encourage them to stand on their own two feet. At Evercore Pan Asset we have been accumulating some holdings in corporate bonds, and looking to buy Asian equities on bad days in markets. We think the recovery when it comes will be better in the exporting and saving countries, than in the over-borrowed economies struggling to pay back debts and needing to raise taxes to deal with large public deficits. Our worries about a possible government bond bubble in the west, which we voiced towards the end of last year, has spread to other investors, and there has been some increase in US and UK government bonds yields as markets focus on the huge bond issuance needed in the months ahead.

It's the banks, stupid

03/02/2009 00:00:00

The Obama package to save the world is now under scrutiny to see if it can save America. Adding too much public borrowing to protectionism is not a winning recipe for success. Markets were inclined to be optimistic about the new President’s plans at the beginning of the year, but are now having second thoughts. Many realise that governments need to fix the banks. The Paulson packages are still unfinished business. The US and the UK economies are not going to function properly again until the problems of their bloated banks are solved. The US and the UK authorities from time to time announce new packages of huge sums of money to help the banks, in between their preferred choice of planning to spend huge sums of borrowed money on public works and projects in the hope these will reflate them out of trouble. There are several solutions being investigated on both sides of the Atlantic to tackle the banks: 1. Establish a bad bank, to take away all the toxic debts from the current banks. The slimmed down banks can then resume lending. 2. Nationalise the existing major banks, pumping in enough money so they can start lending again. 3. Create a state sector good bank which starts lending 4. Offer state guarantees to the commercial banks for new lending to encourage them to start it up again 5. Relax regulatory constraints to allow more lending from stretched balance sheets 6. Print more money and inject it into the banks to encourage them to lend more Proposals One and Two would be very expensive. Transferring the bad debts from private to public sector doers not cure the malaise. It merely shifts the losses from shareholders and bankers to taxpayers for no obviously good reason. There is no evidence that a state owned bank would be better run than a private owned bank, despite the poor performance of several private sector banks. Governments themselves anyway say they do not want to run the banks they nationalise. If more lending is the aim then establishing a new state owned competitor to existing banks and giving it capital so it can lend would be a less expensive way of creating new lending, pound for pound, than subsiding and propping up an existing bank. It could not realistically be large enough quickly enough to make a lot of difference. If it lent too much too quickly it would soon itself have lots of toxic debts, whilst its capital requirements would impose a substantial strain on public finances. Lending in these conditions is not easy, as many companies will struggle to repay the borrowings. Toxic debt is not a large pool of bad loans from a past era of excess that can be identified and tackled. The toxic loan pool is growing all the time as the economy deteriorates. Offering guarantees to stimulate lending, relaxing regulatory restraints on capital and injecting more cash into the banks are all helpful measures. If done in moderation they could help solve the problem. None of this, however, tackles all the underlying problems of overstretched balance sheets, too much dangerous business on banks books, past large errors by banks and a new climate of fear engendered by market movements and government hostility. There are a couple of other proposals in the debate which need to be dealt with: 1. Make the banks declare the full extent of their losses – the full transparency approach 2. Bankrupt selected banks that have performed especially badly to force out their losses and get them behind us The first idea has some merit, but is not of itself a solution. If the losses are too large markets will be spooked and then there will be even larger losses as the market value of banks assets falls further. To some extent this is happening anyway, as auditors and Directors consider what to put in accurate accounts at the 2008 year end. RBS is going to declare around £28 billion of losses as a result. The second proposal was tried when the US authorities allowed Lehmans to go under. It led to further falls in asset values, destabilised other banks and made most in authority think they should not do that again. So what should the authorities do? The regulators and the commercial bankers have to work together where a bank is in trouble, to find a way of getting from over lent, overstretched and sitting on too many losses to a position where the bank’s balance sheet is strong enough to resume normal banking. This requires case by case analysis, and agreement between regulator, central Bank and commercial bank about the timetable for remedial work. All the time the commercial bank is making the agreed adjustments it should receive lender of last resort support, and continue to receive regulatory approval. Actions bad banks need to take include: 1. Cutting costs sharply. They need fewer highly paid people. There must be no bonuses. In some cases higher paid people will need to take a pay cut. These banks need to make more profit to pay the past losses. 2. Going through all loan books and having a plan to maximise the repayments on each loan – as many of them are doing to an extent already. Tough judgements have to made - will continuing the loan and keeping the customer going result in a better outcome, or is it better to demand repayment now because the customer losses and asset values are going to get worse? There was a lot of wishful thinking about property values and the like in the early phases of the downturn. 3. Closing down the investment banking and trading activities that put too much bank capital at risk. The world market has been oversupplied with derivatives, futures, options, collateralised debts and the like. Big book positions should be closed out wherever possible by banks at risk, and losses taken where too many bad bets have been placed. 4. The large banks created by expensive and over rapid acquisitions should be broken down into their old components, re-establishing the separate brands. Individual businesses should be sold off to reduce risk and raise cash. 5. Adding selective new business where risks and margins look attractive, but resisting efforts to make these banks lend to whoever at whatever, recreating past errors of optimistic lending. This is just a sketch of what needs doing. Call it if you like the intelligent bank manager approach. This is a big problem, so it requires hard work and patience to get ourselves out of it. I can see why Mr Obama thinks that if he is going to borrow and spend such huge sums on a reflationary package, he should at least say that the money spent should be spent on American supplies and American labour. After all, he will reason, the point of the package is to revive the US economy, so it must make sense to spend the money on employing Americans. The USA has been importing too much. It would make no sense for the US state to borrow more and spend it on imported Chinese steel or Japanese cars. Unfortunately things are not as simple as that. Drawing up a list of purchases where the US is more likely to win the contracts is one thing. Placing a ban on products and labour from overseas is another. If the USA moves from the former to the latter, other countries around the world may follow suit, making it more difficult for the USA to export its goods. There would be no winners from a trade war. Sometime the world has to address the huge imbalances between countries that lies behind the current crisis. Of the five largest economies in the world at the start of the crisis, two, the USA and the UK were borrowing too much, spending too much and importing too much. Three, Japan, Germany and China were saving too much, exporting too much and lending too much. Part of the crisis lies in the painful process of seeking to adjust to a point where the three exporters import and spend more, and the two debtor countries borrow less and export more. Policies in the UK and the US to borrow more and spend more may delay this adjustment. In the UK the government’s attempts to offset the iron laws of economics have led to a sharp collapse in the pound, cutting the spending power of all of us and putting us off buying so many imported goods. This is offsetting some of the fiscal profligacy and thwarting the government’s hopes of avoiding a fall in living standards. If the US overdoes its attempts to borrow its way out of trouble, it too could run into difficulties requiring higher interest rates and a lower value for the dollar. The US reflationary package is dependent on the goodwill of the creditor nations continuing to hold US government bonds and adding to their holdings as new ones are issued in huge quantities. The world needs agreement between lenders and borrowers. Adjustments need to be made by both groups of countries. The successful exporters and savers do need to spend more and save less. China has announced a reflationary package with that in mind. They do need to allow their currencies to appreciate, so imports are cheaper and more attractive to them. Some of this has happened with the sharp upward movement in the yen and the lesser upwards moves in the Chinese and German currencies. It is in the interests of the creditor countries to reflate, as their economies are being hit hard by the collapse in demand for their exports which have accounted for such an important part of their past economic activity. Germans need to buy more of their own manufactured cars and trucks, and the Chinese need to buy more of their own electricals and textile products, as the debtor nations can n o longer afford to. Markets are gyrating between days of optimism when people think all the money being promised and actions being taken will succeed in getting the major economies out of their downwards spiral, and days of pessimism when investors continue to worry about damaged banks and over borrowed governments. We still recommend avoid the risks of UK real assets, whilst moving some money into corporate bonds and Pacific oriented equities.

Four Different Views on the Credit Crunch

30/01/2009 00:00:00

Yesterday I heard different senior economists give their views of the Credit Crunch and recession and what we could do to get out of it. They gave them under Chatham House rules, so I will call them Views 1, 2, 3 and 4, grouping opinions into the four main different positions at the meeting. View 1 expressed worry about extremes in policy making. Whilst they could live with a modest reflationary package, they are concerned about undue borrowing or money printing, and felt there could be an inflation problem in due course. They also believed that we had to accept a substantial one off drop in national output, reflecting the activity of banks and shadow banks that had gone over the top and could not be continued. They felt that the recession had to take its course, and that policy action of any extreme kind could cause inflation, or fail to stabilise the asset markets. View 2 argued that individuals and companies are very short of money. Money supply has ground to an abrupt halt in recent months. They therefore favored the UK government borrowing substantial sums from the Bank of England or the commercial banks, to spend or give away as tax reductions so the private sector has more money to spend and repay debt. They did not agree with the recapitalization and felt the banks had sufficient capital. View 3 argued that the government had been right to put more money into the banks and might have to do some more. They also felt some money printing may be necessary in current circumstances and agreed there could be a period of underfunding of the borrowing requirement for a bit to generate some more money in private hands. They felt house prices should fall another 25%, preferably quickly, so the market could then be stabilized. They favoured a medium term fiscal strategy to start to reduce the large deficits and reassure markets that in due course Prudence would return. View 4 argued that banks had to go back to simple banking models, relying on deposits from customers as sources of funds and lending to customers as assets. They were pessimistic about how to pull the economy out of recession, and agreed house prices had to fall further.From the discussion which ensued, the following points emerged which I think are correct: - We will lose a portion of our National Output, represented by banking and related financial activities on bloated balance sheets, which will no longer be possible in current conditions. The UK will take a large hit as we have large banks and hedge funds relative to our GNP, and our growth was flattered by the huge financial service expansion in London over the last decade. - Somehow the balance sheets of companies and individuals have to be strengthened, which means they do need more cash and income, at the same time we need more demand from their spending. Some of the extra demand will come from public spending, with tax cuts and benefit payments giving individuals more money to spend. - Creating more deposit money in the banks by underfunding or by the government borrowing from the Bank of England is worth a try. The US is now embarking on something like this. - Increasing future public spending on large infrastructure projects takes too long for the decision to be translated into jobs and spending. Income Tax cuts provide the fastest way of injecting the borrowed public money into the cash starved private sector. - The government does need to construct a budget plan on spending that will start to control borrowing and outlays. - It should remove its VAT cut, and substitute cheaper Income tax reductions.The government needs to cut its risk of losses in the nationalised banks by cost reductions, netting off futures and option positions and reducing its risk to Investment bank type activities. - The government, now it is a bank owner, is the best place to carry out the traditional banking utility function, making its direct contribution to a reduction in Investment banking capacity to reflect the new circumstances. What will the authorities do? In the US now we have both a stimulus package from the new President, and quantitative easing. The announcement that the authorities will buy up Treasury bills and bonds is bullish as it both directly helps those instruments with the extra demand, and as part of a policy of Federal borrowing which is underfunded directly increases the amount of money in private hands. On the other side of the market we need to take into account the rising hostility between the US and China, and the possibility that overseas buyers will not be so ready to purchase US Treasuries this year as before. The US still has pain to suffer, as housing has not yet definitely hit bottom and industry is suffering badly from reduced orders. The banking and shadow banking sector still has some way to go to reduce its activities. On balance we think there is a case for adding to US equity positions on bad days ahead of the monetary stimulus having some impact. Asia will also benefit in due course from any American recovery. In the UK there has been a sharp rally in bank shares from very low levels. This could go further, with forecast good results from Barclays ahead. However, we think the UK economy remains very exposed to this crisis. The IMF has now become the first official forecaster to state that the UK will suffer more than the US or Euroland. Others are likely to follow, as they do the sums on the big contribution financial services and banking have made to the UK economy in recent years, and work on how much of this activity may be lost through the need to shrink balance sheets and find profitable business. We still recommend avoiding UK shares and property. The successful exporting economies of recent years, including Japan, Germany and China, are all suffering from the collapse of export market opportunities in the US and Euro land. It is now fashionable to point out that they need to adjust too, just as the heavily borrowed economies need to adjust. However, they can start from a stronger position than the over borrowed, as they have the savings and reserves needed to stimulate internal demand if they wish. One of the ways the adjustments will be made is by a strengthening of their currencies, which helps the sterling investor in their bonds and shares. Of course we need to recognise that they cannot make as much money as they have been doing from selling to the West, but they do have other opportunities once the shock of the collapse has been absorbed and thought through.

Strains within Euroland, but Sterling weakness should be positive for the UK

27/01/2009 00:00:00

People from the Irish Republic are rushing over the border into Northern Ireland to take advantage of the cheap prices in the shops as they flash their Euros. The shops in Kent and London are welcoming many continental trippers who find sterling prices cheap to them. On Sunday visiting a shopping centre in middle England in Oxfordshire, I was struck by how many of the voices were speaking foreign languages. The market is beginning to work, to adjust the big imbalance in the UK balance of payments. Foreign shoppers will swell receipts, whilst UK shoppers will buy fewer foreign made goods as their prices surge. Families nervous of job prospects and finding it difficult to balance domestic budgets will cut back on foreign holidays. Gradually imports and exports will come into better balance. The danger in the present situation is that many countries and currency blocs might like the sound of devaluation. The UK’s neighbours in Euroland are becoming unhappy about the very strength of their currency which makes UK goods and services such a bargain for them. The Euro area is demonstrating just how dangerous it is to impose currency union on economies and markets that had not properly converged in the first place. There has been considerable worry about Portugal, Italy, Greece and Spain. None of these economies had been brought fully into line with France, Germany and Benelux, the core countries of the currency union. In the early days of currency amalgamation Spain had a boom based on interest rates which were too low for her conditions. Now she is experiencing the reverse, with a high currency and relatively high interest rates driving her asset prices down and giving her a severe economic hangover after the heady days of the boom. Spain’s property bubble was blown to greater size by premature membership of the Euro and a monetary policy which was too accommodating for too long. Ireland experienced exactly the same conditions. Italy has struggled throughout her membership. Used to inflating and borrowing much more than Germany, Italy had for years survived as an exporting country by periodic devaluations. Now she is unable to devalue her way back to competitiveness, so she is suffering loss of export orders and needs to cut wages and restrict costs severely to become more competitive. Greece too has suffered, entering the Euro area with more borrowing and inflation than was comfortable and now experiencing the rigours of a strong currency. The cost of borrowing money has risen for the governments of the weaker economies of the Union, despite the fact that they are all part of the same currency area with some implied obligations from the stronger to the weaker members. The bond markets are becoming more suspicious of the sovereign debt of the heavy borrowers amongst the Euroland governments, placing a risk premium on their money raising. Some Euro critics see in these pressures the beginnings of a breakup of the Euro. They think that maybe one or more of the troubled countries will conclude they need to leave the Euro, devalue, and get more people back to work through such a realignment. Why not take the softer option to price yourself into work, rather than the tough option of staying within the Euro and having to cut wages and other costs? I think this is a misreading of the Euro project. The single currency was always more of a political project than an economic one. The Germans saw it as their contribution to European Union to offer a shared currency, drawing on the legendary anti inflation strengths of the DM. They do not expect other countries to cavil at the necessary anti inflation discipline which they built into the Euro, as they think it is good for all. There is no easy way out of the currency. Whatever the people of the peripheral countries may think of their currency, their governments regard it as a matter of faith to stay in and manage the consequences. EU support for the concept has switched from arguing it is good economically, to arguing that the larger currency bloc gives members some protection from market hurricanes like those that engulfed Iceland recently. At the same time as some members have to accept the pain that the common currency brings them, some are discussing British membership of the Euro again. German sources have confirmed to me that Germany herself does not think this would be a good time for the UK to join, as they are worried that at this rate of exchange the UK is too competitive for comfort. They see the recent large moves of the pound against the Euro, showing that the two economies have not converged. I think the UK government appreciates that 80% of the UK public are still against membership, and understand that the promise to hold a referendum before joining is a pledge they dare not break. Ministers regularly repeat the mantra that now is not the right time to join, even though they stick to the view that in principle they would like to. My conclusion is the Euro club’s membership is going to be more stable than some commentators suggest. Weak countries will be reluctant to leave, and big new entrants will either be reluctant to join or kept waiting before they do. Looking at the economies of Western Europe it is difficult to conclude that the Euro area is a perfect size and shape. It appears that too many peripheral economies with different economic policies and circumstances have already been allowed in. Whilst in due course the expansionists might want to welcome more in, there is a growing realisation that large economies to west and east are different and could prove destabilising for the young single currency. After all, sterling wrecked the Exchange Rate Mechanism, the dry run for the single currency. The pound would prove an over-mighty subject for the currency area, which has enough problems sorting out the pressures within its large and divergent territory. Successful single currency areas usually have more advanced means of transferring wealth from good performing areas to distressed areas, and have a common price for raising public capital. Euroland does not so far have these, so the poorer performing areas suffer more, and governments pay different prices to borrow. Lenders are still not fully convinced that a single currency is forever. In the meantime German and French industry will suffer bigger falls from the strength of their currency, whilst the devalued pound should start to help UK manufacturers if they can have the capital and the stamina to exploit the market opportunity.

Banking in the doldrums

23/01/2009 00:00:00

Today the media is asking who was to blame for the financial crisis in the UK. This is a both a premature and fairly sterile debate. Sensible commentators would conclude that it was a lethal mixture of bad banking, aggressive use of financial instruments, poor regulation, bad macro economic management and poor Central Banking. It is only worth asking if it helps to understand what went wrong so we can try to fix it more precisely and quickly. The UK did not have a credit explosion owing to prior deregulation. Most of the giddy expansion in bank balance sheets and investment banking activities has occurred in the last decade, following the reforms o f the UK regulatory structure in 1997 Yes, the bankers made large errors, overextending their loan books, helping fuel an unsustainable property and share boom, and building ever larger investment banking arms that took on too much risk. Now the UK government owns a couple of banks, it should be changing the business model and sorting out these obvious mistakes. Why don’t they impose some limits on the salaries and bonuses paid at until the banks return to sustainable profitability? Why doesn't it run down the trading activities in futures, options and other financial instruments, to cut the risks? It is true that there are downturns in many countries around the world, and true that the US, Iceland, Ireland, the UK and some other countries have banking problems of a greater or lesser degree of difficulty. This does not mean that the UK government and regulatory authorities did well, and that our problems were imported. Northern Rock was a British business under British regulation lending British money to British borrowers. It went under thanks to bad management and bad regulatory supervision. The British and European authorities allowed RBS to acquire ABN Amro without seeing the potential competitive and capital adequacy issues the acquisition posed. More recently the UK authorities have strangely allowed LLoyds to acquire HBOS, a move which has weakened LLoyds and reduced competition in the market. The British downturn is a nasty one, and owes a lot to the misconduct of UK monetary policy by the Bank over the last few years. So let's summarise the ten worst mistakes of the UK authorities so far: 1. The decision to take powers of daily bank supervision and the duty to raise money for the government away from the Bank of England made it difficult for the Bank to conduct a sensible monetary policy. 2. Changing the inflation target at the end of 2003 led to lower interest rates than were safe. 3. The authorities did not make the markets more liquid to prevent the run on the Rock. 4. Nationalisation of Northern Rock led to the rapid run down of its mortgage book at a time when the residential property market needed more lending. 5. The authorities failed to stimulate a successful private sector deal for the Rock, partly owing to their interpretation of EU rules 6. The authorities were wrong to keep interest rates relatively high for as long as they did 7. The authorities tightened capital requirements last autumn and proposed tightening liquidity requirements at the turn of the year when the crunch was well advanced 8 The authorities were wrong to put equity capital into banks towards the end of 2008, without doing proper due diligence and without demanding prior write downs of bad and doubtful debts 9 The government’s cut in the rate of VAT has not stopped the squeeze on demand but has added substantially to the borrowing requirement. 10 The government’s policy of benign neglect of sterling is adding to the financial strains.

Still bad news for UK Assets

20/01/2009 00:00:00

Yesterday was a bad day for UK investors. The government had to tell us that its first banking package, amounting to £487 billion of share buying, loans and guarantees, had not done the job. They are now planning another package which includes new loans, new guarantees, the possibility of quantitative easing and an insurance scheme for bad debts. The timing of this announcement seems to have been related to the publication of the news of the huge losses at RBS. The government had not completed the negotiations with the banks, and had not filled in much of the detail of its proposals, implying it had been rushed by events. We do not know which bad loans or obligations of the banks will be eligible for the insurance scheme, we do not know how they will be valued, we do not know what the insurance premium will be and we do not know the total taxpayer commitment. What we can guess is that the commitment will be large if the policy is to have any beneficial impact, and that pricing the insurance will be very difficult. There is no static and measurable pool of bad and doubtful debts. In this recession the lake of underwater debt is growing at flood rates. In these circumstances a rumour spread that UK sovereign debt is about to be downgraded by a rating agency, whilst sterling fell again against the dollar and yen. The share prices of RBS and Lloyds plunged, leaving the taxpayer sitting on large unrealised losses on the shares the government has so recently purchased in these two major banks. People often ask me now, how bad can it get? They have in their voices the apprehension of people who still have their jobs but are worried that all the bad news will one day cross their threshold. They are relieved that petrol is a bit cheaper and maybe are benefiting from lower mortgages costs, but concerned that things might get tougher for them in some unforeseen way. The answer is they could get a lot worse. The government has to avoid moving from a very serious problem of weak and over-borrowed banks, to an even worse problem of a weak and over-borrowed state. We need to be able to keep confidence in our currency and in the government’s capacity to borrow and spend sensibly. Were the government to lose the confidence of the bond markets and were the continuous decline of sterling to become a rout of the currency we would be in for higher interest rates, much higher unemployment, and a further cut in living standards for many. The starting point for its analysis should be my simple point that the major banks in the UK are too big for the state to assume all their liabilities, or all their bad debts. The Chancellor yesterday confirmed they were looking at insurance for all the overseas loans as well as the UK ones, and seemed unclear on all the derivative and other financial instrument activities that these banks undertake. Put together, this all amounts to too much risk for taxpayers. The second perception they need is that the private sector is short of cash. Companies are short of orders and revenue, Many individuals are over-borrowed and are having to pay off credit card debts and other loans. They need more money. They are not necessarily going to go out and borrow more, even if the banks suddenly are in a position to lend it. The government does need to work on the money supply to ease the squeeze. The government does need some combination of the schemes it announced in outline yesterday. It also needs to put some limit on the amount the state will spend and borrow, to start to instil some confidence in its own finances again. It should be seeking to dig its way out of its expensive and so far disastrous share buying amongst the banks, and finding cheaper and less committed ways of seeing the banks through a painful period of adjustment. Short term loans against security, the provision of banking cash and maybe guarantees on inter bank and new lending are the least bad ways of doing this. The banks themselves have to cut costs, change their business models and reduce their risks. Subsidising them too much delays this necessary process. Buying their shares just puts the taxpayer in line to pay the losses, which as we saw yesterday are going to be eye wateringly large. We at Evercore Pan-Asset have advised people to avoid UK equities for a long time, and have drawn attention to the dangers of a government bond bubble. The difficulty of stabilising the big banks and sorting out the credit and money transmission processes in the UK still give us concern, and lead us to repeat our advice. We still find many funds around the country with large positions in UK equities. During the worst of the Credit Crunch all equities will suffer, and when recovery is glimpsed we believe overseas equities in the stronger economies should outperform. Sterling has fallen by more than 25%, but there is still the danger of further falls if markets grow more concerned about the level of government borrowing and indebtedness and the imbalances in the UK economy created by a large financial sector.

We are living through two crises

16/01/2009 00:00:00

The first crisis was the massive overextension of borrowing in the credit bubble, which low interest rates and loose banking regulation, off balance sheet financing and a culture of buy now pay later, fuelled in the early years of this century. The second crisis is the gathering slump brought about by the authorities calling a belated time on the credit bubble with high interest rates, tougher banking regulation and the attitude of buying things on credit in the private sector. One of the reasons we are making such slow progress in sorting out the recession is the authorities are still unclear which of these two problems they are fighting, and which is the priority for their attention. Part of their actions are designed to stop another credit bubble, actions which make it more difficult to turn round the slump. It might be helpful to recap the main actions being taken by the UK authorities and to categorise them into one or other of the crises they are trying to tackle. Interest rates These were lifted to higher levels and kept there to curb the Credit Crunch. Rather late in the day these have now been lowered to tackle the recession they have helped create. It will take time for the beneficial impact of lower rates to work through. Capital ratios These have recently been raised and more strictly enforced by the Regulator. This is a policy to prevent another credit bubble, which will make the downturn worse. Banking liquidity The proposals to increase the amount banks hold in cash and bonds are designed to fight the credit bubble and to improve confidence in the banks. It will not help them extend more loans. Money market activity This has changed substantially from very tight money which brought the slump on, to much looser money to begin to combat recession. Loan guarantees The recent proposals may assist in expanding bank lending and therefore increasing bank deposits, an essential prerequisite for recovery. New share capital for banks Given the likely rate of loss in the current nationalised banks this is unlikely to lead to more lending. The danger is it will allow banks to take longer to cut their costs and improve their business models, something they need to do quickly. VAT reduction This was designed to boost demand and therefore economic activity. It is failing to do so, as it did not put any new money into people’s pockets. Income tax reductions would have been better. Not all of it would have been spent, but people do need to repair their own balance sheets before they can spend more. Increased public spending This is also designed to boost demand. It will do to a modest extent. Some of the spending schemes are going to take a long time to get up and running as they are large capital projects with long planning and legal processes to go through before any contract is let. This is a very mixed picture, showing the confusion by the authorities over what they are trying to do. In the meantime the rapid deterioration in the real economy is making the task of turnround more difficult. There are a number of ways the downturn is gaining its own momentum. The banks remain weak. They may well have to write more off their corporate loan books and their property loan books, as asset values continue to slide and as trading businesses experience more difficulties. As the banks are strapped for cash to lend, they are likely to force more companies into bankruptcy, which in turn leads to bigger loan losses for the banks, further undermining their ability to lend to others. Many companies are experiencing unusually large reductions in demand. This forces them to sack more people, as there is nothing for all the employees to do and insufficient money coming in from customers to pay the wages. The more people who are laid off, the less people will spend. Those sacked have less money to spend, and those still in jobs want to repay debt or save as they feel insecure. Companies find potential customers cannot raise the money to buy the goods, or find there is no trade insurance and credit to lubricate transactions. They have to become more suspicious of their suppliers, and require prompter payment from customers to minimise the risk of loss. The tightening of trade credit adds to the financing woes of business. So how does the government break the damaging cycle? It needs to make sure all its policies towards the banks are designed to encourage more normal lending levels. It needs to maximise the favourable impact on jobs and activity that its spending creates needs to control its overall borrowing, allowing for the cyclical increase in the borrowing requirement, so that it can continue to finance itself sensibly. Te government has now decided to consider a “bad bank” financed by taxpayers on top of the loan package, the guarantees and the share capital injections. There are too many initiatives and too large a build up of government borrowing. We remain worried about the position of the nationalised banks and the slide of the currency and in output and orders. We recommend investors to continue to avoid UK equity.

A frightening deterioration in the UK economy

13/01/2009 00:00:00

The British Chambers of Commerce report today that orders, investment and demand for labour all fell heavily in the last quarter of 2008. This will be no surprise to people reading this site. These declines are continuing in the first quarter of 2009. It is the inevitable result of the monetary policy mistakes of a year or so ago, and the weakness of the banking system. The government is now rolling out a couple of additional schemes to assist in saving and creating jobs - a loan guarantee scheme, and a subsidy scheme for employers taking on new workers. Both schemes can be helpful, but both need careful work on the small print. If you are offering a subsidy for a new hiring you need to make sure you are not encouraging an old firing at the same time. If you are offering a guarantee to banks for offering credit, you need to leave the banks sufficiently on risk if the loan goes wrong so the banks do not lose interest in assessing risk properly. As the Chambers of Commerce survey should remind us, these two subsidy schemes are not of themselves going to turn round the plunging economy. Companies need orders. They will not be hiring extra people if their order books continue to fall by anything between 5 and 75%. We heard this morning that JCB are currently producing just 25% of the volume they were making a year ago. No wonder they had to sack another 684 people this week. Companies do need overdrafts and short term loans to be able to pay the wages and pay their suppliers, but they cannot go on doing this on borrowed money if the demand is not there to justify the employee numbers and the material and component stocks. I had a small example of what is wrong yesterday. I had to replace a computer keyboard. The new one turned up in a cardboard box marked firmly "Made in China". This little transaction summed up so many transactions that have got us into our present plight. We no longer have enough repairers or component suppliers in the UK, and have got used to relatively cheap product from China which procurement departments find is cheaper to buy outright. The keyboard was produced by workers probably earning around one fifth of workers in the UK. Many Chinese factory workers will be made redundant in the downturn, as there is a sharp contraction of global demand for Chinese manufactures. They will enjoy little of the benefits and safety net that workers fortunately enjoy in the UK. These hard working and successful exporters are now experiencing more personal grief than we are, as they shed jobs more quickly in their manufacturing heartlands and leave people without a western style welfare fall back. The Chinese as a whole continue to save massively, and invest some of their savings in US and other Western government bonds enabling those governments to buy their products by lending them the money. Recently the pound has fallen. An importer told me the other day that he could go on offering low prices for imports for a bit longer, as he still had some stock bought at better prices, and had some currency cover in place. However, in a few months time this will have run out. Then the UK economy is open to the full shock of a 25% increase in import prices from the collapse of the pound in the last few months. The government hopes that this will not just choke off demand for imports, but will kick start home output at better prices to replace the lost imports. The issue is will it? Normally such a big price movement would change things dramatically. I hope there will be some positive change this time as well. However, we need to factor in the possibility that China(and other low price producers) will actually cut their wages and do whatever it takes to lower their prices again. UK producers may find it difficult to obtain the money, the permits and the facilities to start producing the keyboards and all the other many products we have got used to relying on China to deliver. Prices and currency point to big scale import substitution, but UK companies are badly weakened by low or no profits, poor access to finance, and regulatory complications to expand capacity to drive out the imports. There are no easy solutions to any of this. We do need a drive to substitute home made product for overseas, and need to get used to mending and improving, using local labour rather than automatically reaching for the order form for a complete new overseas product. The currency move will push people in this direction. The danger is our companies are too weakened to respond as vigorously as we would like. In that case we will simply end up buying less and having fewer modern items, and will have missed another opportunity to strengthen manufacturing in the UK. At Evercore Pan Asset we remain of the view that the problems of the downturn and Credit Crunch are especially difficult in the UK, given the three large deficits the country was running when the trouble began. Combining a large balance of payments deficit, a large public sector deficit, and high borrowing by many private individuals and private equity backed companies has left the UK with a lot of work to do in an era of de leveraging. Equity investment opportunities should be better elsewhere.

Is cash still King?

09/01/2009 00:00:00

Last year we recommended a very cautious strategy based around cash. Holding money in good quality deposits earning in excess of 5% felt comfortable, whilst we waited to see just how bad the downturn and the Credit Crunch were going to be. Putting some of the cash into stronger currencies than sterling was a way of raising the returns without too much risk. This year is not so straightforward. The returns on cash on both sides of the Atlantic have plunged, leading investors to consider taking more risks. Sterling has devalued by more than a quarter last year, with much of the fall occurring in the last few months. Equity markets have fallen a long way, especially in the Far East where growth is still stronger and the financial position better than in the US and UK. US and UK government bonds have surged on the back of the falls in interest rates, offering low yields to new buyers. So what should an investor do now? If this were a normal cycle it would be easy. You buy equities as interest rates fall, and wait for the turn to come in the underlying economies as lower interest rates work their magic. The issue before us is the state of the banking systems in the US, UK and Euroland. They remain very weak. There are worries shared by investors, commentators and the authorities that as a result this is not a normal cycle. Lower interest rates may not flow through to increased activity, as the banks remain unwilling or unable to lend much. Final demand for the bigger ticket items like homes and cars has fallen sharply owing to a lack of credit. Businesses struggling with reduced order books then find it expensive or impossible to borrow all the money they need to tide them, through poor trading. Some go bust, and many make staff redundant. Rising unemployment depresses the wish and the ability to spend, further reducing demand. As more companies go under, as house prices fall further uncovering the asset cover for mortgages, so banks have to write more off their loan books and experience more bad loans. There are at least three possible scenarios from here. One is that the banking problems are so severe that none of the actions being taken can mend them quickly, leading to prolonged recession or slump. On this analysis investors have to learn to live with low returns, and remain cautious as there will be more losses in shares and properties. The second is that time will produce a cyclical upswing, given the huge sums the authorities are pumping into money markets and economies, so now is the time to buy equities. Indeed, if the authorities do not reduce the extra liquidity in time there could be a future inflation problem, given the scale of interest rate cuts and the money supply boost. The third is that the authorities will eventually produce measures which enable some modest improvement in bank lending, which in turn will lead to a very slow and mild upswing. On this scenario the Western economies will have to get used to no growth and slow growth for quite a time whilst the debt overhang is worked through. We cannot be sure which of these will develop in 2009. In part it depends on what the authorities do next. Can they, for example, hit upon the right combination of regulatory and monetary responses which can get their banking systems and economies moving again? It remains in the balance. So we try to set out what seems more likely. We think the Asian economies will still grow faster and perform better in the years ahead than the Western ones. The fact that their share markets have fallen further will represent a buying opportunity over the early months of 2009, to add to positions in that part of the world. Corporate bonds offer a much more attractive yield than government bonds or cash. We recommend buying some of the best quality ones on a portfolio basis. If economic recovery develops, they will be re-rated. If we muddle through you should be able to enjoy the better income, and in a slump they will outperform equities and junk bonds which will suffer further from rising bankruptcies and falling profits.

The Bond Bubble?

06/01/2009 00:00:00

Bubbles are great whilst they last. Eventually hubris is eclipsed by nemesis. In the late 1980s I was in Japan at the peak of their property bubble. They proudly told me the land surrounding the Emperor’s Palace, had it been a development site, was worth more than the state of California. I suggested to my British companions on the trip if that little thought experiment were true it was time figuratively to sell the Palace and buy California. So it proved. Over the next decade California took off, pioneering a digital revolution which left Japan standing, whilst Japan wallowed in the aftermath of her property bubble bursting.In 1999 I could not see why people found internet based company shares so attractive – other than the bigger fool theory that they could sell them on to someone else even more love struck by them before the mass psychology changed. People piled their money in to companies that not only lacked any profit and dividend, but in many cases had very little revenue as they were offering much of their service free. Some made big money by not only buying in but selling out before the music stopped. One day people awoke from their trance, and the shares plunged back to earth. In 2006/7 I remember several discussions with property experts in London. I suggested that £120 a square foot rentals in the West End were over the top and the market should fall. They told me there was a continuing shortage of West End property, and the Hedge Funds, the masters of the Universe were in town and could afford it. Now those same experts tell me rents are falling and the shortage of space is mysteriously correcting itself without new build. Maybe the rents were too high after all. Recently I read that people are now lending to the UK government for two years for less than 1% interest. Some seem to think this is a good deal. Inflation is falling. Interest rates are likely to be cut further by the Monetary Policy Committee. People are worried by any private sector risk these days, so they conclude it makes sense to lend to the government at these very low rates. After all, someone may lend to the government at a lower rate next week or next month, so grab 0.98% while you can. On the greater fool theory this may be right. There may well be people who want to lend at even lower rates. The authorities are going to effectively make the banks do this with their new proposals for banks to be more liquid and hold more gilts. Of course if people buy shorter dated gilts they can hold them to repayment so market price movements do not necessarily worry them. Yet I can’t avoid a nagging feeling that when we come to look back on this period of our troubled financial history it will look as if there were a government bond bubble in the midst of all the grief in other asset markets. Only if we go into slump with falling prices, does lending to the government at such a rate provide a reasonable real return. If the authorities now regret the property bubble they encouraged, they should ask themselves if this growing government bond bubble is healthy, and should understand just how much of it is of their making. It could be stopped slowly and gently now, or they could inflate it more and have a bond fall sometime later. If they want to begin to stop it they should announce no more interest rate cuts for the time being, and cancel their proposed new liquidity measures for banks. They should worry a bit more about the inflationary consequences of the big drop in sterling. We are advising clients to look at the higher yields available on corporate bonds. It requires care over timing of entry, and there is still a need to buy a portfolio of the better quality ones as there will be a number of corporate casualties in the months ahead. However, the yields look more realistic on those than on short gilts.

Another Bank Package

05/01/2009 00:00:00

We learn that plans are afoot for another bank package. The first, very expensive, one has not led to sensible amounts of credit flowing in the economy. Despite all the cash and all the words and all the jet travel designed to rescue the banks and get the wheels of credit moving again, the alarming prospects for the UK economy in the first quarter of 2009, has prompted the government to look for more measures to prevent a large number of industrial and commercial company collapses. We were told through the press at the start of last weekend that 4 possible options are being considered:1. More money being invested in bank shares by taxpayers.2. Establishing a state owned “bad bank” to buy up and work through some of the poor loans from the commercial banks.3. Cutting interest rates further, perhaps to around zero.4. Revisiting the state guarantee package for private sector lending.This would be a dangerous package. I would rule out three of those four proposals, leaving just the state guarantee issue on the table. Let me explain why.1. The taxpayer cannot afford to own more bank shares, and should not be expected to take yet more risk. The banks may lose a lot more money before this crisis is resolved. They are currently in a vicious circle. They cannot afford to lend more, so they are forced to undermine the companies they do lend to, as these companies are starved of additional working capital by the banks, and face less and less revenue from customers who cannot get access to new loans or do not seek new loans as they fear for their jobs. It is possible RBS has already lost the £20 billion the taxpayer was made to put in recently. When you go to the aid of a bank with a £2 trillion balance sheet you need a very long pocket. The last lot of share subscriptions did not lead to more lending to the corporate sector – just to lending it back to the government. This is the worst possible option. 2. The Bad Bank idea is a variant of the original Paulson plan in the USA which Gordon Brown criticised, preferring direct injections of capital into banks. The idea is unlikely to work for similar reasons to 1 above. The potential range of poor loans is very large. It would require huge state capital to buy them up, and poses a big problem about how to value them fairly. Value them too cheaply, and you undermine the banks you are trying to help even more. Overvalue them, and the taxpayer ends up with large losses. The sums involved are likely to be too large to be realistic for taxpayers to take on such a task safely. There is the danger of overseas arms of UK based banks seeking to sell their less desirable assets to the UK government at the same time. 3. Lower interest rates is an equally dangerous idea for different reasons. The problem today is not the price of credit but its availability. Cutting rates to zero will create a bigger gap between base rates and actual rates in the market, as no bank can afford to lend to people or companies at a small amount above zero, and no saver is going to willingly put his money on deposit for no return. With sterling already too weak, it would be another incitement to people to put their money abroad.4. The state guarantee package announced last autumn was a potentially good idea. It too requires judgement about how much to guarantee at what price, but offers the scope to help get interbank and bank to company lending moving again at a lower cost to taxpayers. Government can secure the taxpayer interest by taking enough asset cover for the guarantees, but does need to price them sensibly so banks find the option attractive, but not too attractive so the taxpayer is left with too much risk. The lack of use of them so far shows perhaps they were not sensibly priced, as well as indicating that banking regulation may be at the root of the problem.So what should the government do to ease the squeeze?1. Open tripartite talks with the Regulator and the Bank of England over how much capital banks need to have to carry out a given amount of lending. It may be necessary to allow banks scope to have lower capital ratios for a bit as they work themselves through the bad and doubtful debts, with proper monitoring and support from the authorities. They need also to discuss how much needs to be marked to market, and how much can be valued in relation to its longer term economic value, on prudent assumptions about repayment probabilities. At the root of the current shortage of money is the authorities decision to demand higher capital ratios at the time they put more money in, which was a self cancelling move.2. They also need to review their latest liquidity proposals, which will also limit lending to anyone other than the government. These should be delayed.3. Announce there will be no further cuts in interest rates for several months, to create some stability, and offer some reassurance to savers.4. Alter the guarantee scheme following discussion with the commercial banks about what it would take to get them lending more, assuming the taxpayers interests can be properly protected.5. Discuss with markets how the corporate bond market can be made more effective as an alternative source of longer term loans for companies. We would argue that many of the UKs economic problems are related and self feeding. The collapse in demand is leaving many companies short of cash and profit. They need to borrow more to tide them over, but the borrowing is not available. Individuals cannot borrow more to buy the companies products, and then fear the loss of their jobs when companies have to cut back. As jobs go so people spend less, feeling they need to save more. As overtime and bonus payments disappear, so people have less money to spend. Cutting VAT has not unlocked enough spending to save companies. Buying bank shares has not unlocked enough new lending to save companies. This is a big squeeze, which is going to intensify in the first quarter of 2009. Now Christmas and New Year are behind us many companies will have to face the grim reality of too few customers chasing too many goods. Shops will also have some hard decisions to face as they run out of cheap imported product to sell, and have to consider buying product which is around 20-20% dearer thanks to the collapse of the pound. Yes, they should look around for more UK suppliers, but No, they will be unable to source a lot of what they want locally. As the week-end wore on the government let it be known they did not any longner favour putting more share capital into banks. It also appears a review of the capital requirements placed on banks is on the table for discussion. They are considering terms for loans to car companies. Let us hope they soon come up with a package which can provide some relief for a hard pressed economy.

ETF winners and losers in 2008 and prospects for 2009

02/01/2009 00:00:00

Looking back over 2008 it all now seems obvious. Equities were hit hard everywhere as the extent of the Credit Crunch and the recession became apparent. There was a rush into government bonds for safety. Sterling was very weak. As a result you could make good money if you moved out of sterling into the stronger currencies, and could make even better money in some overseas government bonds. The performance of the Exchange Traded Funds we watch carefully showed up the wide range of outcomes. Within equities you could contain some of your losses as a sterling investor by being in overseas rather than UK shares. The All Share ETFs fell by around one third, whereas the MSCI World Index funds fell by less than a fifth. Although the US market had a bad fall in local currency, the fall for the UK investor was less than a fifth. The worst performing ETFs were in areas like private equity and clean energy, where they more than halved. So what do we expect for 2009? It is not so easy as 2008, as shares have now fallen a long way to start discounting the grim economic outlook, whilst the attractive returns on cash which we recommended last year have gone, thanks to a general policy of low interest rates in the leading monetary jurisdictions of the world. Government bonds are now also on lower yields, though it is possible they will fall even further in the short term given the general nervousness about other asset classes. We think it is time to take a bit more risk than just staying with cash or short term government bonds. So we recommend some investment in a portfolio of corporate bonds, bearing in mind there will be more corporate casualties in the months ahead, but taking into the account the deep discount already available in the market for the extra risks. We also would put some money into Asian equity following the large falls, as they will benefit when the US economy does start to turn and to lead the world out of the crisis. We do not think it is time yet to buy sterling, as we fear that the continued deterioration of the government accounts, and the downward revisions to general economic forecasts for the domestic economy still give people little reason to buy the currency, when added to the authorities decision to keep cutting rates. It is true you can also find negatives concerning both the dollar and the Euro, and true that the Chinese and Japanese currencies have been revalued considerably in 2008, but we do not yet expect there to be an early revaluation or favourable reappraisal of the pound. So our advice is to stay reasonably cautious, because the Credit Crunch is not yet over and there is plenty more bad corporate news to come. On bad days pick up some equity in the stronger economies as prices are now much lower, and gain some income through a portfolio of the less risky better yielding company bonds.

Can we avoid another bubble?

30/12/2008 00:00:00

The UK government bond bubble is currently growing large. The government probably wants this to happen, as it knows it has a lot of government debt to sell. But at some point investors and regulators will wake up and see it is not healthy for too many institutions and people to be lending to the government for low rates of interest (gilt yields: short 2.0%, medium 3.1% and long 4.0%), especially if the aim is to inflate their way out of the crunch in due course. For the moment the government can inflate the bubble more – after all there is still a positive rate of interest on longer bonds, and short term interest rates are still above zero. The government is succeeding in taking the available cash at a time when the corporate bond market needs it, and when the differential between government borrowing rates and corporate borrowing rates is very large and in the government's favour. So why does the bubble matter? Lending too much to any company or institution, as we have seen in the private sector in recent years is not healthy and at some point has to be corrected. All the time they can get easy credit they are happy and the system looks stable. Once they cannot get the credit any more people are amazed at how much they were allowed to borrow on such good terms in the good times. The private sector went to the borrowing party in 2005-6. The Bank of England supplied the liquidity, and the banking regulator had to implement the Basel rules which encouraged off balance sheet expansion. We are all now living with the consequences. Now the government has invited itself to a similar party. The liquidity is once again being supplied by the Bank helped and encouraged by the Treasury, with assistance from the other banks and pension funds. The regulator is consulting on changing liquidity rules to make commercial banks lend more to the government (to improve their liquidity). The government has put in a new policy called “strengthening the banks” which entails putting taxpayers cash into some of the banks as Preference capital, so they can lend it back to the government at a running loss. The foreign exchange markets currently do not approve. Maybe they have read the detail of the Chancellor’s statement and do understand that this year’s borrowing is not £78 billion as advertised but a massive £157 billion or more than 10% of National Income. Maybe it is just the advertised promise that the government will borrow 8% of National Income next year that worries them. Maybe it is that and the weak performance of the UK economy, though Euroland and the US will not perform well either. Maybe it is thinking ahead to the losses about to be recorded by UK banks, including those that the government has invested in. Whatever it is, something has spooked the currency markets. Sterling hit $1.45, 131 yen and 1.03 Euros yesterday. The slide continues unabated. So what should the government do about the runaway borrowing, the bond bubble and the collapse of the currency? It could: 1. Signal that interest rates have fallen enough. 2. Cancel the proposed regulatory requirement for banks to buy more government bonds 3. Relax regulatory capital requirements on the banks as they declare write offs and create more realistic balance sheets 4. Start to cut the nationalised banks costs – they need to make some money to offset the losses 5. Indicate there will be no more government share capital for banks – future support for banks will be based around short term loans against proper security 6. Look for ways to get its capital back from the banks it has put share money into – through asset sales, cash sweeps and refinancings 7. Cancel the VAT reduction, and replace it with cheaper better targeted recession busting tax reductions In the meantime the gap between the yield on corporate bonds and that on government bonds looks high. Of course there will be more bankruptcies and refinancings ahead for the corporate sector, as trading is very weak for many and the New Year will bring us more bad news. Any investment in corporate bonds needs to take into account the possibility of rapid fall from grace of some large companies, and the general hostility of the economic climate worldwide. However, as interest rates fall and yields on government bonds grow smaller the relative attractions of corporate bonds increase, chosen on a portfolio basis from amongst the stronger companies. It is also possible to use overseas corporate bonds to give funds more exposure outside sterling all the time the government ignores the fall of the currency.

What price cash?

23/12/2008 00:00:00

In 2008 cash has been a great asset. It has given an income of more than 5% in sterling for much of the year. If UK investors have ventured into other major currencies they have usually made money. Cash has been solid as most other assets have plunged in value. Looking back it was an easy call to make, to stay in cash or to raise cash through sales of other assets as the banking crisis developed. 2009 will be tougher to call, for two main reasons. Cash now yields under 2% in the UK. Interest rates have fallen or are falling sharply in all the major centres. Investors can no longer rely on a reasonable yield as well as the capital certainty of cash. At the same time, most other assets now look so much cheaper, as they have fallen so far. At Evercore Pan-Asset we look carefully at yields on assets. If we could believe the yield of more than 6% on UK shares they would be attractive to us, but we don’t. We expect plenty of dividend cuts in the New Year, ranging from banks that cannot pay dividends until they have repaid government capital through manufacturers that need the dividend cash to pay the wages and redundancies, to retailers smarting from poor trading. The yield on “safe” government bonds has already tumbled, but there are still plenty of buyers looking for a relatively safe haven that still yields a bit more than a wholesale cash deposit. We expect in 2009 investors to gradually take on a bit more risk in order to get a bit more income. Pension funds may decide to buy some more corporate bonds, for although there remain hazards ahead for companies with too much borrowing, the safer corporate bonds have very attractive yields which pension funds and charities might wish to lock in. In the early weeks of 2009 investors are still likely to be pushing money into longer term government bonds, especially in countries where the balance of payments figures and the government deficits are under reasonable control. Governments themselves and banks are likely to be buying some longer dated bonds to push the prices, though we need to be aware of just how much some governments are going to have to borrow as they pursue their reflation strategies. Currencies will remain volatile, as investors sell those backed by governments which are borrowing too much and by economies that are especially weak. Governments themselves are likely to be important players in currency markets, with several major countries now worried about their currency becoming too strong for the comfort of their exporters. We are recommending picking up a bit of extra income by taking a bit more risk as we enter 2009. Investors also need to remember that you will need less income to take care of inflation, as it is likely inflation will continue to fall rapidly in the New Year. For smaller investors in the UK there are still some better deals to be had by placing deposits in a range of banks and building societies keen to compete for funds, and National savings still offer better rates than the money markets afford.

The next bubble - government borrowing

19/12/2008 00:00:00

At Pan-Asset we worried prematurely that the UK government’s wish to borrow so much would cause strains in the government debt market. Indeed, we underestimated their intelligence in this respect. Forecasting a huge surge in government borrowing from the £43 billion for 2007-8 heralded in the Budget to around £120 billion, I discovered that the government now thinks the true figure is an eye watering £157 billion for this year, or more than 10% of National Income (although most journalists and commentators continue to use the well-publicised £78 billion figure). This could have been more than markets would willingly lend, creating new strains on our currency and long term interest rates. Instead, the worry today is that despite the huge increase in government debt we will witness a further increase in the size of the government debt bubble. Government debt prices have been rising. How can this be? The government has taken strong steps to ensure lots of buyers for their debt.They are instructing the banks to buy lots of gilts (government debt) to “increase their liquidity”. Much of the money the government has put into the banks to “strengthen” them will be lent back to the government at a loss! They preside over a pensions regulatory system which will force many more companies to increase their pension contributions, and will encourage Actuaries and other advisers to insist this new money is stashed in gilts. Taking interest rates down to very low levels will undermine the returns of most savers in normal deposits. Some of them will be tempted into government debt through National Savings and related products. Injecting huge quantities of money into the system through the Bank of England will also create large amounts of liquidity to let institutions buy government stocks. They are creating a huge money go round, where the Bank of England bloats its balance sheet, to create the cash to power the government debt bubble. In the short term the government has designed a system which will allow it to borrow colossal sums at low rates of interest. At some point this will have to be unwound. Just as the property bubble burst and the commodity bubble burst, so one day the government debt bubble will burst. In the meantime, we believe there may well still be benefits from investing in short to medium duration gilts but would avoid the longer-dated issues.

Why aren't banks lending more?

16/12/2008 00:00:00

The government thought the following would lead to more normal lending levels: 1. £37 billion of new equity for 3 banks 2. Nationalisation of 2 mortgage banks 3. £450 billion of short term loans and guarantees for banks 4. Much lower interest rates 5. A big increase in money market liquidity and substantial open market operations by the Bank of England They thought all of this would bring LIBOR down close to the base rate, in turn leading to banks lending again to home buyers and businesses.Now it is not working they have added: 1. The reflationary package, based on a VAT cut 2. Much higher levels of public borrowing 3. Lecturing the banks So why isn’t it working? 1. The banks still have to write off substantial bad debts. HBOS last week revealed an additional £8 billion of write offs, three quarters of the new capital the government is supplying. If all or most of the new capital just matches losses it cannot be used to lend more. 2. The Regulator has chosen this bad moment to demand more capital and cash to sustain existing levels of lending. As a result new capital above the write offs does not necessarily allow any new lending. 3. Banks are lurching from being too confident to being very cautious about new lending. They are now reluctant to lend as they fear more losses. 4. Further big losses are emerging, as we learn today concerning a large US Investment fund. Such losses hit confidence and in some cases impose more direct losses on banks. 5. The Regulators are requiring banks to rely more on retail deposits and less on wholesale money. Retail deposits are dearer, making it more difficult for banks to make profits. Loss making banks are weak banks, unable to lend more. 6. The two nationalised mortgage banks are effectively winding down their mortgage books. This means far less mortgage money is available in the markets, leading to further falls in house prices. This in turn leads to more mortgage loan losses for the banks. 7. The sharp deterioration in business conditions in the UK, US and EU in the fourth quarter of 2008 will create more corporate loan losses. Bank executives are busy fire fighting problems in many of their customer companies. 8. The Regulator is going to require the banks to hold a lot more in gilts so they are more liquid. In other words the banks are going to be made to lend more to the government! What can be done? It is not easy breaking a vicious circle of less lending, more losses, less lending. The government should summon the Bank of England, the Regulators and the lending banks. It should say it wants to change the terms of its £450 billion package to make it more effective. The Regulator should be asked how it could be more counter-cyclical to make it easier for banks to lend in difficult conditions. At the moment regulatory and monetary policy are pulling in opposite directions. That needs to change. The government needs to find a market answer to allow Northern Rock and Bradford & Bingley to lend again. It needs to find a way to limit taxpayer risk in RBS.If they carry on in current mode we should expect more property price falls, more bankruptcies, more job losses and more bank loan losses. This is not a great backdrop for recovery. Whilst it is important the government stands behind the main UK banks to avoid another Lehman disaster, it must avoid feather-bedding them. Taxpayers should not be subsidising six figure salary executives and their bonuses. The financial sector generally has been paying itself too much. The sooner costs and charges are cut, the sooner more normal business can resume. The serious allegations about a large US investment fund show us how little a big Regulator achieves. The very least we should now expect is for the Regulator to help solve the current problems instead of making them worse. Putting in tougher controls to prevent the excesses they allowed a few years ago just digs us deeper into our current hole. This is the background to Evercore Pan's continuing caution concerning the UK economy and share market.

Senators' auto accident highlights risks in US real economy

12/12/2008 00:00:00

Today the markets are discovering there is one thing worse than a Democrat Congress trying to agree pay cuts for US Autoworkers allied to a tide over loan for the big three car companies, and that is no deal at all. We are in the second phase of the economic crisis, when the centre of the action moves from the banks to other industries. The combined impact of falling demand from the monetary squeeze and a shortage of cash for major companies will have a bad effect on employment levels, factory closures and local communities adjacent to the big plants. Meanwhile in the EU there is a dispute at the summit. Mr Brown for the UK wants international endorsement of his borrow to cut VAT policy. The German administration thinks the UK’s level of borrowing is unacceptably high and risky. They have no intention of signing up to a common course of action for all EU states based around the UK model. They and some others think you cannot solve a crisis of over-borrowing in the west, by borrowing even more. Nor do you make weak private sector concerns strong by transferring them into the state sector. Germany and Poland are leading the charge to dilute the climate change agreement to limit the costs to their high carbon using industries. The western economies are still badly placed, as they seek to live with malfunctioning banks, with erratic and risky Central banking monetary policies, and governments which have in some cases lurched from complacency to panic in recent weeks. I was pleased to learn from media sources that the UK government does privately accept it has to revisit its £450 billion banking package, and try to find ways to make it work better. It had better hurry, for the sharp deterioration in the rest of the economy will generate more bad loans for the banks, undermining their reserves and their confidence further. This week’s NIESR prediction of a very sharp drop in UK economic output in this fourth quarter of 2008 represents a more pessimistic view than the government’s recently published new forecast, and feels closer to the reality. Some companies report problems with powerful suppliers wanting down payments, and difficulties in obtaining credit insurance and trade credit, at the very time when banks are reluctant to maintain let alone increase overdraft facilities. Out in the real world of trading companies there is no sign yet of the Credit Crunch being over, or even of the Brown plan having “stabilised” the position. Banks report the need to cut more jobs. In the UK where there is now substantial government involvement in bank share ownership there are difficulties in deciding how to price loans and to remunerate savers, with political pressure to offer more to depositors and to charge less to borrowers. As the banks need to generate more profit to be able to build up some reserves, to repay government Preference capital and then pay some dividends, this is going to be a difficult set of exchanges and decisions. At Evercore Pan Asset we remain negative about UK real assets. We are beginning to look at some UK corporate bonds where investors want to have some sterling assets against their sterling liabilities, but recognise that there remain covenant risks in some cases, even at these price levels. We prefer Asian investment for the recovery, and regard the yen as the best of the major currencies.

UK banks in a costly government debt Merry-go-round

09/12/2008 00:00:00

We are enjoying a rally in shares based on expectations of a major reflationary package from incoming President Obama, on top of the substantial fiscal loosening carried out by President Bush to subsidise and recapitalise financial institutions and motor companies. In the UK the government and regulators are revealing how they think they can borrow £157 billion this year, followed by another high borrowing year next year. They will tap into three sources of demand for government paper. The banks will need to be substantial buyers, as the authorities are currently consulting on proposals to “significantly” tighten liquidity standards for banks. The pension funds will need to be buyers, as their black holes come to be filled by more company contributions which the regulators and actuaries will direct to a considerable extent into gilts. There will also be some volunteer buyers, concerned about equity risk and taking note of the large buying demand from the first two sources. Many investment managers who held large positions in equities during the 2008 collapse are now increasing their government bond holdings. The trouble with this approach by the regulatory authorities is that it makes increasing bank lending and getting things moving again in the real economy that much more difficult. Compare these two regulatory statements: “We continue to expect Basle II to result in a reduction in our regulatory capital requirement compared with Basle I” (Northern Rock Accounts published in 2007) “Firms will be obliged to hold sizeable buffers, and we would expect a marked increase compared with holdings under the predecessor regimes” (FSA December 2008*) In the heady days of 2007 before the August tightening of the money markets, many banks like Northern were lending large sums, and were concluding that they could either lend even more or return some capital to shareholders under the future regime. Today banks are told that they need to hold a lot more in liquid government bonds, lending to the government at low rates of interest. The FSA itself says that its new policy will entail a substantial revenue loss for the banks. Capital that could have been employed lending to companies and individuals at higher interest rates will be lent to the government at low rates. The FSA says of bank turnover* “...diminution in revenues – this diminution could be in the order of £1-5 billion (or even higher if the spread between the yields on government bonds and other debt widens)." This change to banking capital is a fundamental one and will mean less lending and therefore a slower economy. The Regulators no longer like reliance on some wholesale market funding, where banks borrowed through the money markets. Instead Regulators wish banks to rely more heavily on deposit taking from the High Street and the web. Paradoxically it was the High Street deposits which pulled Northern Rock down, for it was only when that run became apparent that action had to be taken. Aware of this the Regulator says a bank needs more cash and government bonds as a buffer. That means lower bank profits, which in turn means the banks have less capacity to lend to others. The round trip of money between banks and government should be seen in this context. If we take the example of the money lent to 3 of the banks as Preference capital by the government at 12%, we can see what damage this does to banks profits and therefore to their future balance sheets. The money effectively has to be lent back to the government at 4%, leaving the banks with a loss of around 8% each year, or £1100 million of losses between them. Far from strengthening the banks, this adds to their problems. The UK Stock market has rallied a bit on the back of US hopes. It is going to take a stronger banking sector to get back to proper levels of growth, however much money the UK government flings at it. In the short term the UK government has come up with a way of paying for its bills by borrowing, but borrowing too much from the UK banks makes it more difficult for them to lend to others. *Source: Financial Services Authority CP08/22 “Strengthening Liquidity Standards”

Falling pound, falling interest rates, growing recession

05/12/2008 00:00:00

The interest rate cuts we have been anticipating are now coming through thick and fast. This week has seen 100 basis points off UK rates, and 75 basis points off Euro rates. The Fed and the Bank of England are both ballooning their balance sheets in a rash of monetary activism, but still the commercial banks are reluctant to step up their lending. Regulatory caution requiring better capital ratios, the difficulty in accessing wholesale market funds, and the perceived increase in the riskiness of consumer and company lending are all impeding an expansion of lending. The collapse of the real economy is also proceeding apace, as we feared. The centre of attention in the USA is the auto industry, as the CEOs of the big three US auto assemblers battle it out on Capitol Hill for public support and subsidy. The politicians are rightly demanding a proper plan to get costs down and to improve the model range to increase future sales. Even the Autoworkers Union has pitched in with some proposals for cutting labour costs, working on the basis that they would rather have some pay cheque than no pay cheque. The CEOs who were criticised for their travel plans and lifestyles, have promised to forgo the executive jets and some of the remuneration as they grapple with an industry that has let its costs run away with it in the face of leaner and meaner foreign competition. In the UK more financial sector job losses have been announced, whilst the once very successful New Star investment management business needed to ask for new share capital from its lending banks in a major financial restructuring. This means that a majority of the shares are now owned by banks which in turn the taxpayer has major shareholdings in. It is another example of how in this climate more and more of the risk is being taken on by the taxpayer and the state, directly or indirectly. We at Evercore Pan-Asset have remained very cautious, still favouring substantial cash holdings. We have remained bearish of the pound, which has continued to fall against the yen, the Euro and the dollar. The market reaction to the last 100 basis point interest rate cut was typical of the current mood. Sterling fell and shares also fell a little. Normally you would expect such a large interest rate cut to ignite interest in shares, as people tired of cash yielding less and became more excited about the prospects of recovery. The poor state of the banking system still weighs on the markets. Some pension funds are reducing their equity exposures after substantial losses, and there is still some flight from hedge funds and other actively managed equity vehicles. We are watching the banks and the government’s many stimulatory actions very carefully. We have no doubt of the strong wish of the US and UK authorities to lift the recession. They are now using all the weapons in their armoury, of lower rates, more liquidity and fiscal stimulus. Both economies are going to experience high levels of public borrowing, as more and more risk is absorbed by the public sector. In the case of the UK the imbalances are worrying large, and the regulatory pressures on the banks are sending mixed signals. We continue to advise avoiding UK equity and property investments.

Rate cuts will damage Sterling if spending is not reduced

02/12/2008 00:00:00

On Monday the slide in sterling speeded up, with the pound having its worst day since the collapse following sterling’s troubled times within the Exchange Rate Mechanism in the early 1990s. This is no surprise. We have been recommending investors to avoid sterling assets all year. The Monetary Policy Committee of the Bank of England turns out to be as ill-judged as the ERM. The ERM led to inflation first, then recession, by forcing the country to take interest rates which were too low, followed by rates that were too high. The Monetary Policy Committee has done exactly the same thing, without the excuse that they are on autopilot determined by the value of the currency. They have resolutely steered the vehicle by looking in the rear view mirror. They are now about to make their third big error, of setting rates too low for the extent of government borrowing and the fears in the international community about the UK’s financial situation. They left lowering rates too late, helping push us into a bad recession. Now they are taking undue risks, because of the fiscal expansion. Fear of low rates is one of the factors behind the sterling collapse, because investors think the UK is still borrowing too much. The truth is that both the UK and the US have to cut living standards. For years both these economies have been living well beyond their means, thanks to easy access to credit from the strong exporting nations and commodity producers who were generating big surpluses. It has been possible for both the great Anglo Saxon democracies to run large balance of payments deficits, large government deficits and large deficits in the personal sector. People and governments have spent too much and borrowed to do so. Now the world’s markets are saying enough is enough. Living standards in both the public and private sector have to be brought down. The private sector has to sell more abroad and consume less at home. The government sector has to get closer to just spending what it can collect in taxes. The problem is that whilst the recession will force the private sector to contract, there is currently no mechanism to make the public sector take some of the pain. The outgoing President, Mr Bush, is a high spender who sees no need to rein in spending at the end of a long period of overspending. The incoming President, Mr Obama, was elected to spend more. The Prime Minister in the UK thinks spending and borrowing more is the right thing to do in the circumstances, and is busily trying to bail out chunks of the private sector which would otherwise have to adjust more quickly to the painful reality that we have been living beyond our means. On both sides of the Atlantic the authorities have made the decision that most manufacturing will simply have to contract, shedding jobs, closing factories, putting people onto three or four day weeks to slash pay. Meanwhile they have perversely decided to feather bed the bankers, who are arguably more inefficient and much more highly paid than the manufacturers. Both administrations have poured money into banks which should have been told to raise their own capital by reining in their expenditures. The authorities should have given them temporary loans, not permanent capital. I see no reason why taxpayers should pay bankers bonuses in these conditions, when the finance industry needs to get its pay down quickly to sort itself out. This week has seen bad figures from the UK’s Purchasing Managers Survey, pointing both manufacturing and service sectors into a bad recession. Confirmation has come that the US is in recession and has been there all year. The authorities are now beginning to accept on both sides of the Atlantic that the Paulson and Brown packages have not so far unfrozen bank credit. In the UK many companies are reporting withdrawal of bank facilities or big increases in charges and interest rates. We continue to advise a cautious approach to investment, with high cash positions, avoiding sterling based assets. There are opportunities on bad days to buy Asian assets at better prices, even though these too are adversely affected by the stresses in the US economy.