All eyes on Obama

Posted on: 10 February 2009 by Gareth Hargreaves

Financial expert Graham Kerner digests the global economical situation.

Once again the jeremiahs were not disappointed last week as a welter of poor economic news dripped into the markets, confirming what everyone knows – the global economy is going through a particularly sticky patch and the end still seems some way off.

The media seem to have given up trying to keep a tally of the jobs being cut globally, but one only needs to look at the unemployment numbers to grasp the situation. The Daily Telegraph reported that Spain lost 200,000 jobs last month as its property-led boom implodes and the government fears 4 million  will be unemployed by the year end.

And it’s a similar picture across the eurozone too, with German industry suffering its largest fall in output since unification. In the UK, production at British factories suffered its largest slump in 35 years, but on the positive side, The Times said that we may have seen the first, tentative signs that the pace of the economic slump may be easing.

The headline purchasing managers’ index – spanning businesses from accountants to hotels – climbed for the second consecutive month albeit still below the key level of 50 that indicates stability. But the real shocker came on Friday when data showed that US non-farm payrolls fell by almost 600,000 in January – the largest single drop since 1974, taking US unemployment up to 7.6%, the highest for 16 years.

Ordinarily, investors might have expected global equity markets to fall given the grim news, but increasingly the markets are displaying great stoicism – mainly because the bad news has already been priced-in. Last week’s reaction supported this argument because instead of falling, markets rallied smartly with most of the major indices adding a few percent – London enjoyed its best rally this year, ending the week up 3.43%.

The Financial Times explained that hopes have intensified for a speedy passage of President Obama’s US economic stimulus package which is expected to top $900bn. Commentators believe that the stimulus would justify record borrowing by the US Treasury with the markets focusing on the impact on the economy from an aggregate demand perspective.

But the paper went on to say that some Republicans are not wholly convinced; with Senate minority leader Mitch McConnell saying “Putting another $1 trillion on the nation’s credit card isn’t something we should do lightly”.

Behind the scenes there are concerns about the package masquerading as a stimulus with so-called pork-barrel politics taking over and thus raising fears of a huge spending spree. President Obama has made an impassioned plea for Congress to bury its differences and pass the bill and it seems that financial markets believe that ultimately this will happen.

In the weekend press The Sunday Times speculated that last year’s US bank bail-out may face a radical overhaul with President Obama’s administration keen to improve the poor public image of America’s bail-out. Treasury Secretary Tim Geithner is due later today to announce a wide-ranging road map to put the banks on a stable footing and the markets are keenly awaiting his address.

Of course, bank bail-outs are not peculiar to the US. Last week The Times reported that Russia’s government threw a $40bn lifeline to its banks as the rouble suffered another pounding, prompting speculation that the country would be forced into formal devaluation.

Russia’s finance minister said it was conditional that the funds should be passed on to the real economy. Here in the UK, Britain’s leading banks have availed themselves of the Bank of England’s special liquidity scheme to the tune of £185bn in an attempt to fund themselves through the financial crisis.

The Daily Telegraph reported that in total, Britain’s lenders have packaged up £287bn of mortgages to swap for Treasury gilts to the end of January when the scheme closed. However there are it seems concerns that the value of the assets pledged has already fallen to £242bn which means the BoE could ask for more payments.

More Cuts

Not jobs but interest rates. On Thursday the BoE announced a further half-point cut in UK interest rates bringing the cost of borrowing down to 1% - the lowest in history. Whilst the cut came as no surprise it means there are winners and losers: the former are borrowers and the latter are the thrifty who increasingly are seeing their savings’ returns savaged.

However, Mervyn King, the BoE governor, will say this week – according to The Sunday Times – that the cuts do not mean savers in Britain have been abandoned. Rather, the argument is that radical cuts will help speed the economy out of recession and allowing rates to return to normal.

But as The Financial Times noted, with average savings accounts paying just 1.08%, savers are effectively seeing a negative return on cash after allowing for tax and inflation. Eurozone savers may have breathed a sigh of relief though because the European Central Bank left borrowing costs unchanged at 2% last week – despite obviously poor news on the economic front.

Ironically though, companies wanting to borrow money from the markets to fund their investment plans via the issuance of corporate bonds are finding they are having to pay more – anything up to 5% over a corresponding government bond.

But this has thrown up opportunities for investors seeking to increase their income, as The Daily Telegraph pointed out, saying that with people unhappy about the performance of equity markets, the attraction of a bond from a well-known company paying a yield of 8-9% becomes self-evident.

And there is no shortage of supply – or indeed appetite - because last month corporate debt issuance recovered to levels seen in boom times with some $246bn being issued and bought by investors.

Here too, the BoE is keen to give a helping hand it seems as it outlined its asset purchase plan last week. The plan is intended to help unblock frozen credit markets through its £50bn facility which will allow it to purchase not only commercial paper (used by companies to borrow for up to 90 days) but also corporate bonds - the net effect should increase liquidity and ultimately drive down longer-term borrowing costs for business.

The market’s view is that the recent recoveries in corporate bond markets also reflects the transfer of risk from the private sector to the state and so are happy to buy what they see as re-packaged government debt.

Nil Desperandum

After a dismal ten years for equity returns, many investors are likely to have questioned the merits of owning them. There is no refuting the evidence – data from the Barclays Capital Equity Gilt Study, which analyses returns going back 110 years, confirms the last decade was the second worst on record.

But as The Sunday Times said, battered investors would be wrong to lose faith: prospects for future returns look their best for a generation and the paper reminded readers that over 50 years equities have delivered the best returns of any asset class.

The paper went on to say that, although the FTSE100 is down 28% in capital terms and 1% with dividends re-invested over the decade, top investment managers can do much better and would have easily beaten the market. The two managers named were Andrew Green of GAM and Neil Woodford of Invesco Perpetual who delivered returns of 180% and 145% respectively over the period – and both manage money for St. James’s Place clients.

The article went on to say that, according to analysis by Fidelity International, which studied every complete 10-year period using the Barclays data, buying shares at the end of a lost decade as bad or worse than the last one, has failed to at least double the purchasing power over the next ten years on only one occasion since 1899.

So whilst the numbers may not look so attractive in the short-term the conclusion to be drawn is that longer-term equities can be very attractive.

On The Contrary

By coincidence, Andrew Green last week talked about the portfolios he manages for St. James’s Place and explained the rationale behind them.

“These are difficult times – the challenge for me as a fund manager is to position the portfolio for the recovery which will ultimately come but in the interim avoid any potential damage.

“We are currently operating in a no-confidence market so the catalyst for recovery will be the realisation that the worst is past and as a consequence the funds are invested to be ultra sensitive to any increase in confidence. So from a defensive point I continue to hold around 20% liquidity, with the rest dependant upon a global recovery.

“The 24% in Japan is fifty percent hedged from a currency point and contains some small banks, larger companies such as Fijitsu, some small cap pharmaceutical stocks and a few technology stocks. Japanese banks are for the most part untainted by the toxic asset issue but have another issue – they own substantial equity holdings, which is why the government is keen to buy these assets from them to free up lending.

“With interest rates falling fast, the hunt for safe yields is driving investors towards the large cap stocks – the likes of BP and Shell. The problem for me is that these stocks have done well in the last ten years and are not cheap so I am reluctant to own these.

“My own strategy is to hunt for value from a capital stance so I am looking for companies who will outperform on the way up. For now I continue to be patient because there is a real danger that dividends may be cut so I would prefer to own something like BT which yields 14% - my rationale being that the capital value is already badly depressed and if the dividend is halved it will still be 7%.

“For now though I seem to be in a minority which is unsurprising I suppose coming from a deeply contrarian investor.

“I think Europe is expensive and I have doubts about the sustainability in the government bond markets – high levels of borrowing will need increased debt issuance so yields may have to go up, depressing capital values.

“Having said that, we are in extraordinary times and governments could easily buy long bonds themselves to force down yields so there are many unknowns. I now own two banking stocks, the first for ten years and of course it’s possible that the government might fully nationalise Lloyds and RBS but it is a risk worth taking because the potential upside is significant.

“Against this backdrop I am taking extreme care within the portfolio, but mindful of the danger of missing the recovery in stocks if I become too defensive. At these levels the rebound in prices – when it happens – will be very fast and one could easily miss the first 20% by trying to re-position.

“After the last great bear market in the Seventies stocks rose 150% the following year which highlights the danger of being wrong-footed. So in the meantime it’s all about preservation of income and capital.”

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