Evercore Pan-Asset

It’s been a great start to the year, just as we hoped. We turned bullish about China towards the end of last year and added to positions in various portfolios. That market has risen well in the first few weeks of 2012, and is one of the leading risers. Brazil is putting  in a good performance. Even India, still with inflationary difficulties and much higher price earnings ratios than many other emerging markets, is rallying sharply. Foreign investors, who fled the country in 2011 making it one of the worst performing markets, are starting to return.
 
The reasons for the improvement are clear. The world economy is still likely to grow satisfactorily this year, and ended last year with another good overall growth performance thanks to the figures from the emerging market world.  The Euro problems have been temporarily eased by a massive injection of liquidity into the EU banks by the Central Bank. Markets have been told to expect continued very low interest rates in both the UK and the US, are anticipating falling rates in much of the emerging world, and now think the ECB will join the UK and US with easier monetary policies. The biggest threat to world progress last year was perceived to be the collapse of EU banks and the disorderly break-up of the Euro. So far this year that has receded as a prospect. The US economy put in a better performance at the end of last year, and is now in Presidential election year. Investors do not expect unpleasant surprises from the US authorities in such times.
 
So what could go wrong? The biggest risk remaining is still the Euro zone. Italian and Spanish bond yields have come down from the danger zone as bank liquidity eases. However, Portuguese bond prices have continued to fall and yields to rise, whilst Greece remains in dire straits. We are promised an orderly and agreed hair cut on Greek state debts, but it is taking a long time to negotiate it successfully. There could still be an accident in one of the most badly damaged Euro countries. The Euro countries that are staying in the zone without special loans are also in some cases still very stretched financially, and are in recession. They have not tackled the underlying problems of excessive deficits, and too little growth sufficiently. European banks remain weak. They have limited scope to lend more, even if the ECB keeps them afloat with plenty of cheap money. The US and the UK have the benefits of devaluations and loose official money, but they too are struggling with limited bank credit growth and with large debt overhangs in both public and private sectors.
 
For the time being we think valuations of shares still look cheap by historic standards. Money is going to remain cheap and plentiful, at least in the charmed world of the western banks and governments. Authorities everywhere seem to want to make things easier for the moment. We will watch like hawks as the Greek and Portuguese problems unfold. The most likely thing to stop the progress would be another severe leg to the Euro crisis, coupled with high banking stress. Middle Eastern political tension could also get worse.  Meanwhile, enjoy the market momentum. It is especially good in Asia.

The New Year has started in better sorts than the third quarter of 2010. Investors in riskier assets are a bit more confident. Market participants at last recognise that there will be economic life beyond the Euro area, however bad the Euro crisis becomes.

If we divide the world into three large blocks of countries, The US, the EU and the emerging market economies, we can see that prospects for 2012 overall are not too bad. The US figures for the last quarter of 2011 were better. As we enter Presidential election year, the US administration will be straining every sinew to get unemployment down a bit more and to show progress with the recovery. The Fed is unlikely to rock the boat, continuing with very low interest rates. If the economy weakened too much they might well contemplate more quantitative easing. It is true there are doubts over the tax breaks, and a wish by many legislators to start the task of cutting the public deficit.  Despite that, we agree with many forecasters that the US will grow reasonably this year and US company earnings will continue to advance. 

In the EU problems remain in Euroland. There has been temporary respite from the massive injection of liquidity provided by the Central Bank to the commercial banks. The banks and others have managed to buy enough government bonds in Spain and Italy to allow those countries to carry on borrowing or refinancing in the normal way through the market, without the need for a visit to the IMF. They even managed to keep sovereign bond yields fairly stable when S&P was downgrading the credit status of 9 states. Nonetheless, we should expect recession in parts of Euroland this year as they continue with austerity policies. We should expect more fears and alarms over the solvency of some EU states. The markets may have to handle a default by Greece, or swallow a settlement of the Greek debt problem which will entail very large losses for the private sector holders. The ECB will have to provide plenty of support to the banking system in another troubled year. There’s going to be little or no growth in the Euro area as a whole.
 
The emerging markets should have another good year. They grew well in 2011, but got little credit for that in jaundiced markets. That has made shares in countries like China and Brazil look even cheaper. This year the main countries can cut interest rates, and increase bank credit. They had a year of tighter money and rising rates last year, which is not such a good backdrop for share investment. Some worry that China and others will suffer badly from falls in EU export markets for them. Their dependence is not high, as the majority of China’s exports go to Asian destinations. There is also great scope to expand Chinese domestic demand. The main aim of the current Five Year Plan is to do just that.
 
The UK is likely to do more to try to lift its growth rate. On top of quantitative easing we have been promised credit easing – more money to lend to the corporate sector. The government is interested in a range of infrastructure projects, and in the power to deregulate company activity.
 
So what should an investor do in 2012? It is time to consider a bit more risk, if you became very cautious in 2011. The prospects look most enticing in the emerging market economies. There the combination of low valuations in many cases, the authorities’ scope to relax monetary policy, and the growing ability of these countries to sell to themselves and each other looks attractive. 

As published in Investment Week

The IMF has slashed its growth forecasts again for the Euro area, and for the UK. The latest UK GDP figures showed an economy slipping back a little in the last quarter of 2011. Many now think 2012 will also be slow going, whilst most forecast a recession in the Euro area this year.

This has not phased equity markets so far in 2012. They like the low interest rates, the money printing schedules of the UK and the large credit lines suddenly made available by the European Central Bank. The markets are more relaxed, taking news of difficult conditions in the real economy in their stride. After all, they argue, it just means interest rates staying lower for longer, and more monetary easing.

The US and UK authorities have used a variety of policies to try to promote growth. They have adopted ultra low interest rates. The US has just announced that these are likely to last until 2014. The UK has also suggested low rates are here for longer. They have undertaken quantitative easing to inject more money into the system, and to keep long government borrowing rates low. Both countries have run large public sector deficits. For all the talk about spending cuts, the UK in particular has pressed on record levels of public spending. They have not spared the much favoured “Keynsian stimulus”, deficit financed public spending. The UK Coalition government reduced the inherited proposed cuts to capital spending, and is now seeking to put together larger capital projects which can be partly or wholly privately financed as an additional stimulus. It is seeking to pump prime the housing market.

The Euroland area has done less until recently. They kept their rates a little higher, and even put them up before coming more into line by lowering them again. They held off quantitative easing, but have recently injected large sums into the banking system from the Central Bank to replace liquidity lost by a freezing of the inert bank market. The ECB has bought some sovereign bonds to try to stem rises in long term interest rates in the weaker countries of the zone. Euro countries have largely spent and borrowed more than the limits set out as part of their common budgetary discipline. Germany recorded a reasonable growth rate for much of last year, but the prognosis is now for weaker growth or declines in output across the currency area.

Investors are going to have to get used to slow growth or no growth in many parts of the west. Japan after her large credit bubble in 1990 settled down to a long period of ultra low interest rates, big increases in debt and slow growth. In Japan’s case the monetary laxity did not trigger worrying inflation. Indeed the economy often hovered on the edge of deflation. The equity market never recovered the peaks achieved in the bubble, though it has enjoyed some good bull runs within the pattern of being well below past highs.

The US is the nearest to getting some momentum. This is probably owing to the speed of its adjustment to the banks and the sharp contraction in property values, getting a lot of the bad news out of the way early. It also owes a lot to the strong enterprising spirit visible in a good rate of company formation and the application of new technology to markets. The Euro area still has not resolved its currency problems, and still has a lot of work to do to strengthen banks so they can support more lending again. Meanwhile, in the emerging market world, things look a lot more promising.

It looks as if the US and the UK might turn out to be lucky. Both economies are deep in debt. Their private sectors borrowed plenty on mortgage in the good times to buy property before the Credit Crunch. Their public sectors, never shy about high spending, have borrowed colossal sums to help steer through the last few years of monetary and banking disruption. So far creditors have kept faith in them.
 
Lenders have provided more funds to the UK, impressed by tough government rhetoric about deficit reduction. More importantly, the Bank of England has resumed a large buying programme for UK state debt. Lenders have carried on making advances to the US, impressed by the world’s superpower status and largest economy, and reassured that the US can always print some more dollars to pay the bills if all else fails.
 
There is, however, something more substantial on the horizon. Both countries have made significant discoveries of shale gas. The US is more advanced. They have identified big shale gas deposits in the Eagle Ford region of Texas, the Mancos find in Utah, at New Albany Illinois, Haynesville in Louisiana and Macellus in the North East amongst others. The US seems keen to drill and exploit these new resources. It means lower gas prices, more domestic production, less reliance on imported hydrocarbon. It makes an important addition to the asset side of the US balance sheet. It points to better balance of payments figures in due course.
 
The UK has found gas at Blackpool. That is said to be part of a large field, though it will take more wells to prove the scale of the reserves. Geologists reckon similar conditions favourable to gas shales are common elsewhere on the mainland of the UK. There might be planning and environmental issues to be resolved, but it seems difficult to believe a hard up Britain will turn its back on these important resources.
 
Both the US and the UK have felt vulnerable to energy price rises. They have reluctantly become more dependent on Middle Eastern oil, whilst the EU becomes ever more reliant on Russian gas. Oil has had a big impact on their relationships with Middle Eastern countries, and has been the background to large military commitment and expenditure. If these two countries can become more self reliant, drawing on the new hydrocarbons they have found as well as on the renewables they are putting in, it will be good news for the economies.
 
If you are deeply in debt you often dream about a windfall inheritance or win. They rarely turn up. Maybe for the two leading Anglo Saxon economies one is in the process of arriving. Even if the eventual recoverable reserves turn out to be less exciting than early forecasts, every little helps.

Markets have enjoyed a better run recently. They have tried to put the Euro problems out of their mind. The big injection of liquidity by the European Central Bank into the commercial banks helped. The relative stability of sovereign bonds in the EU despite downgrades of credit ratings also reassured some investors.

We do think China, Brazil, and some of the smaller emerging economy stock markets offer good value. The rally has started after last year’s sharp and unwarranted sell off, but valuations are still low for areas offering substantial growth. The latest Chinese figures show modest slowing of growth, but even the bears think China will carry on growing at 6-7%, way faster than the west. There is still so much scope for people to leave low paid jobs on the land and to go into the cities for better paid employment. There is still great scope for wages to rise, giving Chinese domestic consumers much more spending power to buy their own home produced goods. China will be a larger economy than the USA when living standards are still less than one third of US living standards. Given the energy and determination of many Chinese, that does not seem too distant a goal.

The bears about China say that her exports could be badly damaged by Euroland collapse or recession. Only one fifth of China’s exports come to the EU. Worse Euro problems would be a temporary loss of some part of the growth, rather than a fundamental problem that brings collapse on China as well. China would probably accelerate her expansion of domestic demand to keep the factories turning. She is busily engaged in strengthening her trade links and related investments throughout Asia and Africa.

The bears also point to the weak finances of much of China’s local government. It is true there has been over spending and too much borrowing. It is not, however, on a western scale. It should be possible for the Chinese state to manage it, with a mixture of toughness and central support.

We increased our exposure to China for most portfolios towards the end of last year and wish to run those positions. We are also pleased to see Asia ex Japan and the wider Emerging markets indices having a good period for performance. Our Pan Aggressive Fund has extensive exposure to these areas and will benefit strongly if they continue to perform well throughout the rest of 2012.

There has been plenty to worry about in recent months in the UK. Many investors and commentators have told us how much damage a Eurozone collapse could do the fragile UK recovery. Even a prolonged period of Eurozone weakness as they struggle to keep the currency together damages export markets. The government’s Autumn Statement revealed as we predicted a major downwards revision to its deficit reduction plan, with slower growth in revenues and two extra years to get the deficit under control. There has been plenty of discussion of more austerity. None of this has made a good backdrop for equity investment.

We have been very cautious about the UK. We have typically invested nothing or very little for our discretionary funds in UK shares. Last year demonstrated why, with a year of declines in the Stock market as investors revised their expectations downwards. The prices of shares vindicated our stance. As we entered the New Year investors were still worrying about the possibility of a double dip UK recession, the danger of more downward revisions to forecasts, and the further damage which a worsening Euro situation could do.

We now think you can overdo the gloom. This year should bring one good piece of news for the UK. Inflation should at last tumble. As forecasters who have repeatedly warned that the Bank of England has been far too optimistic or complacent about inflation, we now think at last the Bank’s optimism is more justified.  Inflation at over 5% did a lot of damage last year. It cut into people’s living standards badly, cutting real domestic demand as real incomes fell. This year we expect a succession of energy price falls, the ending of the VAT effect on prices, intense supermarket and High Street store price competition and pressure on retail margins. This will help get inflation down substantially, relaxing the squeeze on real incomes and limiting the decline of domestic demand.

We also expect the government’s stance to become easier. Credit easing is expected to be rolled out soon. The Chancellor promised it in the Autumn Statement and will have to have it working for around the time of the Budget. He has also promised more capital projects to help the construction industry. London may lose some of its normal tourist business this summer, but will still get a boost from the Olympics. It will be the world city of the year, and will attract some high spending visitors as well as tons of publicity. I doubt the authorities will worry much if the pound weakens a bit more, as in the short term this will not offset the inflation falls and may help exporters a bit. I expect the government to pick up on its promises of promoting recovery, and to find actions in the budget that reflect the words of the Autumn Statement.

The London market is not expensive on yield or P/E grounds at 3.3% and 10.8.  There are still things to worry about. The UK public finances still are in a weak shape. Euroland is far from resolved. The UK is going to experience slower growth for some years as it gets over the massive debt hang-over in both the public and private sectors. Retail rents have further to fall, and office properties outside London are not a great investment. Nonetheless, at the margin we are less negative than we were. This is because shares are now cheaper, investors are more pessimistic, and some things, especially inflation, are beginning to go right.

We think savers have been getting a raw deal. Deposit rates are low, and income on some defensive funds is also disappointing. We have been doing a lot of thinking about the poor rates of return and low levels of income available to the investor that does not want to take much risk, and come up with an answer.
 
We have made changes in Pan defensive so it now offers the investor a 5% running income. We have changed the balance between bonds and shares to an even more cautious 95/5 in favour of bonds. We have not moved into low grade bonds with very high yields. We do not want to make this a much riskier fund.
 
We have made some changes that increase the income in what we think should be a prudent way. We have sold the very successful holding in index linked global bonds. This year should see inflation subside in the UK and several of the major emerging economies. We think it is less of a fear this year, and index bonds went up last year, depressing the yields. We have bought some longer term high grade corporate bonds which offer a bit more income than the shorter term ones we mainly owned last year. We have added a holding in emerging market sovereign debt, which yield considerably more than prime western bonds for no very good reason. 
 
People who take the trouble to save, who are prudent and want to put something by for a rainy day or for some future purpose, deserve some reward for their trouble. It’s been a poor few years if you just keep your money on deposit. We think we have come up with a fund which can give you some income to spend now if you wish, without drawing on your capital, or more income to roll up in your fund so you have a bigger pot for the future.

Last year was not a good year for UK pension deficits. Many pension trusts experienced a dull year at best for investment returns, with many pension funds losing money overall. Meanwhile the unthinkable happened, and gilt yields fell still more. As the gilt yield is an important variable in the measurement of pension fund liabilities this on its own increased deficits substantially. Actuaries calculate the deficits in part by asking how much gilt edged stock the fund would need to buy to ensure payment of all the future pensions from the income on a gilt. The answer just got bigger, when other assets in the pension funds got smaller.

Shell, the last FTSE company to have an open final salary pension plan has now decided to close it. Some 20 years after the UK could proudly announce it had the best private sector pension provision in Europe the pensions landscape looks very different. Most private sector final salary schemes have closed to new members, and some have closed for further accruals for existing members. Many are in deficit, and some are in wind up.

As funds mature the advice is usually to hold more in “safe” bonds and less in equity and other more risky assets. Many funds have prematurely aged by virtue of closing to new members and in some cases to new accruals altogether. We agree that more in bonds has been a wise course in recent years, but have favoured higher yielding high grade corporate bonds over gilts to gain the advantage of the extra income these bonds have supplied.  The last decade has seen an unusual pattern to investment returns, with the total return on UK government stocks exceeding the total return on US or UK or European shares. There has been no advantage to holders of these riskier investments to compensate for the greater capital volatility.

Today 10 year gilts only yield 2%, and long dated gilts only offer 3%. By historical standards these returns are very low. They also look low in relation to the rising costs of offering pensions. It would be surprising if we had many more years when gilts outperform other mainstream investment assets. Gilt valuations have been flattered again recently by the UK authorities decision to buy up government bonds from the secondary market in order to keep the interest rates on the debt low.

We think Pension trustees need to look at other ways to bring the deficits down. Past experience over the last decade says that a suitable mixture of higher yielding good quality corporate bonds, and some equity investment in the faster growing parts of the world like China and Brazil offers the best chance of earning decent returns to start to bring down those deficits. It is true that if and when gilt yields rise the deficits automatically fall. In the meantime it is never wrong to make a better return on the money you do have invested, whilst taking suitable precautions on the amount of risk you are prepared to run.  We are happy at Evercore Pan-Asset to advise pension funds on their investment approach, with a view to tackling the deficit.

Yesterday Italian unemployment figures came in at 8.6%. That is bad news for many Italians, but by Euro area standards it was a good performance. An astonishing 23% of the Spanish workforce is unemployed, including 45% of young people. 18% of the Greeks of working age, 14% of the Irish and 13% of the Portuguese rely on out of work benefits for their living. Even in France almost 10% of the workforce is without a job.

The Euro has delivered a series of uncompetitive economies in the south. It delivered a credit and property bubble in Ireland and Spain which is proving painful now it has burst. It has created a very weak banking system throughout the Euro area. The currency requires countries in trouble to cut spending and raise taxes as their prime policy, hitting the private sector as well.

Yesterday was another bad day for the Euro in other ways. UniCredit bank shares fell another 14% on the back of their deeply discounted issue of new shares to buttress their capital position. In sympathy Euro area bank shares generally fell by around 5% on average in just one day, following a prolonged period of weakness in recent months. Investors worried about the volume of new bank shares the other banks will need to issue, and assume they will be able to buy those at well below current prices, as UniCredit shareholders have now discovered in the case of their company.

Hungary, a candidate to become a member of the Euro saw her bond rates forced up to almost 10.8% and is now seeking help from the IMF. Italian state 10 year borrowing rates went above the magic 7% again, whilst Spanish 10 year rates also rose to 5.6%.

The ECB’s giant injection of more cash has not injected the confidence in the system that all hoped. Mr Monti, the new technician PM of Italy, has had to travel to Brussels for more talks. Sarkozy and Merkel will be back together attempting another package to save the Euro, probably next week. The truth is the Euro system has unleashed a banking crisis on the back of a sovereign debt crisis. They failed to keep banks’ capital up to sensible levels in the better days, and are now behind the curve in the bad days. Meanwhile the over-borrowed governments are struggling to raise the colossal sums they need to keep going. Spain briefed the press about another 50 billion Euro hole in their figures brought on by property losses and weak banks.

Meanwhile the news from the USA is better, with more growth and more jobs. There are also signs of growth to come in the emerging market world. We continue to advise investors to avoid Euro area risks. There is now some reward for backing the more successful parts of the world economy. We have enjoyed good returns on emerging market and US investments over the last quarter.

As 2012 dawns, some say expect more of the same. Last year was a bad year for share investment, a bad year for investment in many European bonds, and a disappointing year for most alternatives. If you held a portfolio of gold and US Treasury bonds you made money. Most of the rest varied from the weak to the dreadful.
 
It is true the Euro crisis is a long way from resolution. It is likely there will be a recession in many of the weaker Eurozone countries, given the policies being followed. It is possible there will be more losses on European bonds and banks, as the authorities struggle with the problems. It is true the UK is finding deficit reduction elusive and difficult. The Triple A credit rating assumes success in the battle of the bulge. 
 
We are more optimistic than that. Last year saw the shares of Asia and Latin America brought low by their own policies to curb inflation and slow their economies, and by fears of the damage the Euro crash could do to them as well. We think this has been overdone. As NED research have recently pointed out, half of China’s exports go to Asia, and only one fifth are destined for Europe. Meanwhile Brazil and China can cut interest rates, stimulate bank lending and take other action to speed their growth rates. Such moves are usually accompanied by rising share values. There are many millions of consumers in the emerging world who are going to be better off this year, and use their extra income to buy more goods and services. 
 
The US performed better than most of the rest of the west last year. Its economy still has some momentum going into the new year. It is also election year, when the administration will be keen to keep things moving forward and when the Fed will be reluctant to be too tough. Asian and American property looks good value and allows investors to participate in the growth in these continents with a bit more protection on the income stream.
 
We think 2012 is a year that may start with many fears and worries, but could end more positively. Chinese shares look cheap – they are certainly not on bubble ratings. The rest of Asia looks set for another good year of growth, as do parts of Latin America. We have been adding to share markets that we think can deliver. The relative size and valuation of markets does not reflect the superior growth prospects of the emerging world, though it does now reflect to a greater extent in Europe the very real problems that still lie ahead for the Euro.