‘Grand’ gestures with minimal effects, Europe is doing the ‘Ice Bucket Challenge’ with a glass of water. Measures won’t measure up to much. Little movement in interest rates, not enough assets to buy and ultimately – you can put out as many cream cakes as you’d like, but if people aren’t hungry, they aren’t going to eat. The pressure is rising and more is needed. Europe has become a ‘binary trade’, and it is important to invest in those set to benefit regardless.
(Click on the image below for a quick video clip summary)
As U.S. stocks and the European equity index ended last week in positive territory, against a backdrop of disappointing data, market moves seems misplaced. Instead, Central Bank action is cosmetic not medicinal, a tool for reassurance not economic change. Developments from the recent EU Summit are either temporary or limited and capital remains restricted. However, economic deterioration heats up the pressure for action.Therefore, Central Banks are damned if they act and damned if they don’t. For sentiment to turn, we need to see signs of stability, as well as support.
Central bank action is being met with scepticism, and initial market rallies used as selling opportunities for profit taking. This is because moves are cosmetic and not medicinal, as in the short term they may reassure markets that measures are being taken, but they are of limited effectiveness at significantly boosting growth. Even Draghi himself, the President of the European Central Bank, argued “price signals (have) relatively limited immediate effect”. They won’t stimulate demand and, by potentially hurting bank profitability, could reduce the incentive to lend – the opposite of the target outcome.
Nevertheless, for the first time, we have seen the ECB cut the benchmark interest rate below 1%. In the same week, the Bank of England announced it will be increasing asset purchases by £50m. With weak US data and Bernanke already cautious, the pressure will be on to turn ‘Operation Twist’ into a more traditional waltz. Investors will be hoping the Fed will pump more liquidity into the system instead of ‘twisting’ or neutralising purchases by selling elsewhere along the yield curve.
Summit Moves Are Limited
The outcome of extensive talks at the EU Summit likewise fuelled a ‘false rally’. Spanish government bonds have since returned to hover around the unsustainable 7% level again despite developments. Instead, the 3 key ‘achievements’ are temporary or limited, as explained below…
1. Senior not guaranteed: Investors have been moved higher up the pecking order and will now be repaid for loans made to Spanish banks before the bailout fund. Being the ‘first’ in line to get money back is indeed an improvement but crucially the risk of loss is still there and may continue to worry the markets.
2. Wishful thinking? The government has been removed from the equation with bailout funds now able to offer loans to struggling Spanish banks directly. Removing government involvement in bank bailouts to protects sovereign bond yields ignores the possibility investors will continue to view the health of the banks as a driver of economic health.
3. Bond buying boost limited: Bailout funds may now buy debt directly from “solvent countries” (read: Italy). However, this is a limited source of demand and again short-sighted.
Capital Remains Restricted
The size of the problem remains a key concern and a crucial measure missing from the Summit was a substantial strengthening of the ‘firewalls’. At €500bn, the rescue fund is only 20% of the €2.4tn combined debt burden of Spain and Italy. The risk that a lack of funding will leave European leaders unable to stop the crisis spreading remains.
Economic Deterioration Heats up the Pressure for Action
With a backdrop of a deteriorating economic environment, Europe is far from able to ‘grow out of the problem’. German manufacturing deteriorated for 4th consecutive month. Relied upon as a rare source of growth, the outlook is dimming. European unemployment has reached its highest level since the creation euro. This is unlikely to spur spending and instead put the pressure back on Central Banks to do something to kick-start economic growth.
Therefore, Central Banks are damned if they act and damned if they don’t. For sentiment to turn, we need to see signs of stability, as well as support.
Note some of this article has been published by the Financial Times
As the US launches $400bn ‘Operation Twist’ in a desperate attempt to kick-start the economy, concerns arise over how effective this will be. It’s true that something needs to be done and inflation restricts the options open to the Fed but the strategy has a poor track record in terms of effectiveness. We will be in a lower growth environment for longer and should prepare accordingly.
The Economy Struggles: Something needs to be done
The US remains driven by consumer spending (~70% of GDP), but weak consumer confidence and limited access to financing are severe headwinds. Unemployment is stuck at 9% and even more worrying are the ‘under-employment’ figures which include those that have been forced to cut their working week rise as far as 18.5% of the population. In addition to discouraging spending, the longer this continues, the more skills are being eroded. Therefore the US government is under an immense pressure to act.
But inflation restricts options
So what can they do? When conventional monetary policy has become ineffective, since short term interest rates are already low, that’s where quantitative easing steps in. With the aim of stimulating the economy, the Fed will buy financial assets in order to inject money into the markets. Bernanke has made it clear that one of the pre-requisites is a re-emergence of deflationary risks. However, inflation remains stubbornly above 2%. Pumping more money into the markets increases its supply and therefore reduces its value. With the currency less valuable, it doesn’t go as far as it used to and you get less ‘bang for you buck’. Things seem more expensive and inflation has been boosted.
Operation Twist to the rescue?
There is hope. One form of quantitative easing avoids the problem of inflation – Operation Twist. The strategy still involves the Fed buying long term government bonds, but in this case, it’s offset with selling short term bonds. This avoids flooding the market with cash which would exacerbate inflation. Another way this method is also described, by selling short term bonds and buying longer term bonds, is an extending of the maturity of Fed’s bond portfolio. Buying these long dated bonds increases demand and therefore reduces the amount of interest the bond issuer has to offer to entice buyers. A reduced longer term rate makes for example mortgages (long term borrowing) more affordable which would hopefully encourage spending.
A Poor Track Record
History teaches that Operation Twist may be of limited use. When it was applied back in 1961, it only reduced rates by 15bps! This would not be enough to encourage spending, hiring and boost the economy sufficiently.
What can you do?
Prepare for a lower growth environment for longer. Pay attention to the type of customer a company in which you’re interested in investing services. A strong balance sheet, pricing power and protected demand will serve firms well.
Gemma Godfrey, Chairman of the Investment Committee and Head of Research at Credo Capital, and John Authers of the Financial Times on CNBC’s European Closing Bell. Discussing how you should invest your money.
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The problem with international meetings is politicians are often “more interested in their next job than the next generation” – Anonymous source via Anthony Hilton, Evening Standard
Political turmoil has hit the three largest European economies in recent days. Portugal’s Prime Minister resigned, Merkel’s party was ousted from the most prosperous state in Germany after an almost 58 year uninterrupted rule and at France’s recent election, abstention reached a new high at 54% of the population. What are the main issues to be watching, how are they affecting investments and why is the term ‘decoupling’ now being used to describe countries within the EU?
In reaction to recent French takeovers of Italian companies, Italy is threatening to draft a bill to curtail the trend. France maintains the bill will go beyond measures conceived by Paris and tensions look to worsen as the French EDF, the largest shareholder of Italian energy company Edison prepares to replace the Italian CEO with a French counterpart. Indeed with David Cameron concerned about maintaining an open and competitive continent, the issue is one to watch. Nevertheless, with a high savings rate and exposure to German and Emerging Market economies, the outlook for Italy remains strong. In a recent auction, the maximum amount of index-linked bonds targeted was sold on Tuesday, €6bn year to date. Domestic demand remains strong.
Spanish Growth Downgraded
Another European country with issues of its own and yet resilient market reaction is Spain. The Central Bank sees a growth outlook of 0.8% for this year, lower than the government’s expectation of 1.3% growth. Unemployment is still among the highest in Europe at ~20% and they are implementing some of the deepest austerity measures to bring their deficit inline with that of France. Nevertheless, markets are forward looking and are reacting well to the aggressive policy implementation. Spreads on Spanish bonds over the equivalent German versions continue to narrow.
Even more worrying is the 43% youth unemployment (as quoted in The Guardian), higher than both Egypt and Tunisia - leading Gregory White at The Business Insider to call Spain "The Next Egypt" http://read.bi/i7fKOu. Source of chart: Miguel Navascues, an economist who spent 30years for the Bank of Spain following a posting for the US http://bit.ly/fDGb6k
Germany Facing a ‘Blocking Majority’
After another disappointing election result, the governing party of Germany could face a ‘blocking majority’ if they lose one more state in the September elections. Inner-party opposition is looking likely to intensify and after abstaining in the UN’s vote on the ‘no fly zone’ over Libya, fears of a return to isolationism have returned. Together this could compound the indecision that has dogged Merkel’s leadership so far. Nevertheless, the country’s deficit is set to fall as low as 2.5% of GDP.
Therefore, the markets are starting to differentiate between countries. Spanish and Italian equity markets are almost 9% higher than they were at the start of the year while others are still struggling. Most interesting is the lacklustre return of Germany’s equity market despite stronger fundamentals. Although this can be explained by the idea that markets move not by information on an absolute basis but relative to past performance and most crucially – expectations. With this in mind, Italian and Spanish economies are seen to be improving and doing well versus investor-set benchmarks.
The Investment Insight
There are many more hurdles along the way. The yield on Portugal’s 5-year notes surpassed 9% for the first time since Bloomberg records began (1997). The average yield across maturities lies at 4%, but the trend is upwards and once a 6% level is reached, it is argued it will become near impossible to reduce the countries debt-to-GDP ratio. In the immediate future, today’s results of Ireland’s banking stress tests will reveal the additional capital required for adequate solvency. As always, it is wise to maintain context, exploit contagion to your benefit and focus on quality for the longer-term.
“Quality is never an accident, it is always the result of intelligent effort” (Ruskin)
There appears to be at present a major discrepancy between quality and value – which reminds me of the Oscar Wilde quote that “a cynic knows the price of everything but the value of nothing”. As I highlighted in a prior post, What’s Driving the Markets and How Should I Invest?, investors have seemed to push up the price of lower quality companies, leaving an opportunity to invest in companies of higher value with upside potential of reversing its underperformance versus its index. I will now show how despite there being question marks over the value of the wider equity market versus its long-term average, against other asset classes the investment case looks strong – and there’s much cash waiting on the sidelines! Just remember – Quality, Quality, Quality!
Valuations may be unconvincing…
As you can see from the above chart it is arguable that relative to its long-run average, the equity market is fairly priced to slightly over-valued. To explain, using the same great blogger who sources the chart , the avid “Charter” of financial data, Doug Short: “The Q Ratio is a popular method of estimating the fair value of the stock market developed by Nobel Laureate James Tobin. The total price of the market divided by the replacement cost of all its companies. The mean-adjusted chart above indicate that the market remains significantly overvalued by historical standards” — 41% to 52% (depending the version of calculation you choose).
… But risk premium is stretched…
US Cyc-Adj Earnings Yield (Non-Fin) vs. US Real Return on Cash (%). Source: Capital Economics
Despite my point on valuation, the above chart shows how little all the cash sitting on the sidelines is earning their investor and in stark contrast to the earnings yield some equities could be providing instead – a mighty enticing motivation to invest.
This highlights not only the motivation for a move from cash to equities, but also a switch from government bonds to equities. When discussing earnings yield it is interesting to remember Warren Buffett’s quote that: “earnings can be pliable as putty when a charlatan heads the company reporting them”, lending support to my focus on quality companies which includes the requirement of good management.
I showed in my previous post, How to Play the Bond Markets, how the case for bonds is no longer a “broad-based trade” and investment grade spreads are now 63% narrower than at their 2008/9 peak and now below 2002 levels.
… And it’s Not the Time for High Yield
Moving on to high yield, credit appears to have recovered much more than equities. The below chart (which will be uploaded tomorrow – an exciting insight from Merrill Lynch) shows that the last time high yield (called high grade (HG) in this graph) spreads were near 200 bps, the S&P 500 was between 1,400 and 1,500, vs. only 1,181 currently (20/10/10). (To keep this post short and snappy, I will explore this in more detail later)…
INVESTMENT INSIGHT – How to Invest
As previously expressed, this has been a low quality rally, driven by low quality, high beta names (exemplified in my chart showing US Consumer Discretionary which should be the most affected in a recession driving increases in the wider market) – Therefore active management remains key – sector and stock divergence
This is a ‘stock-pickers’ market. Invest in high quality companies (strong balance sheets, cash flow rich) which have the upside potential to re-rate to their intrinsic value and having underperformed during the periods of market over-exuberance.
“Our lives are defined by opportunities, even the ones we miss” (F. Scott Fitzgerald)
I think the above title is apt for much of life, including the investment world, and the credit crisis was one such opportunity which served to make or break many mangers out there. A “broad-based” bet on parts of the fixed income asset class was enough to extract alpha. Now things are slightly trickier…
Investing is no longer a call on the asset class alone, but rather an emphasis on specifics is coming more into play. Spreads have narrowed, from their historically wide levels (see chart below from an excellent fellow blogger the Calafia Beach Pundit, Scott Granis, the former Chief Economist at Western Asset Management and Seeking Alpha certified) but Corporates are focused on managing and strengthening their balance sheets. Differentiation in returns can be seen between sectors and between names. Thus, the key going forward is credit selection and a focus on quality.
I remain cautious on the high yield space, concerned with the possibility of the default rate coming in higher than expected and with lower levels of credit available to struggling companies, the recovery rate disappointing on the downside. This again highlights the importance of being name specific when investing. With spreads narrowing as far as the above chart shows, the risk / reward profile of this part of the asset class is not as attractive.
INVESTMENT INSIGHT: Be name specific, focused on high-quality companies with strong balance sheets
The search for yield is becoming an ever tougher quest for investors, especially the more cautious amongst us. Arguably, the easy money has already been made within the fixed income space; cash offers little as an investment vehicle and many question what the growth drivers will be behind many developed market economies and stock markets. Thus we are left asking, where should one invest?
We also need to question the type of environment we are investing in. Government action will be highly influential as it exits from its policy of Monetary Easing. Timing will be crucial but almost impossible to get right. Too early and we risk dipping back into recession and experiencing the destructive forces of deflation; too late and the threat of rampant inflation rears its head. The consensus is that the government will favour the latter option as the lesser of two evils. Either way, any recovery the world sees may be a volatile one and clarity may remain elusive. Concerns over debt are still acute and here in the UK the Government predicts expenditure, revenues and debt are to get worse before getting better.
Thus I highlight the importance of an active management approach to investing, where the manager has the ability to react quickly to the changing environment and provide protection on the downside. Focus is also on being selective within each asset class. Although no longer a broad-based trade, opportunities remain within fixed income, with quality paramount and the focus on being name specific. Equities are looking more interesting. Nevertheless, with the potential for corrections in the markets in the near-term, investing with long / short managers, who have a proven track record of navigating the choppy markets of the last few years successfully and who are well-positioned to exploit opportunities both on the upside and downside, is attractive.
Emphasis is on being pro-active rather than reactive and continuing to monitor the changing economic and market environments closely.
ALLOCATE TO EQUITIES
ANTICIPATE A MARKET PULLBACK (i.e. invest via long/short managers able to protect on the downside)