Bad news out of Europe, Germany in particular, makes two potentially profitable outcomes significantly more likely. Firstly, the European Central Bank will be more flexible in its efforts to keep Greece in the Eurozone. Secondly, there are fewer roadblocks in the ECB’s way for announcing further QE. Policy is diverging. While the US contemplates tightening, Europe is exploring the opposite. Resulting currency moves could provide a welcomed boost to European exporters.
Bad news for Europe, good news for investors
Investor hopes for ‘government bond-buying’ QE were raised today as Germany came under renewed pressure.
As the Euro zone crisis intensifies and global markets reflect investor concerns, we ask ourselves, is a Greek exit from the euro on its way? Crucially, preparations have already begun to protect shareholder interest, companies are robust and policy in the US and China aims to maintain the upward momentum. To protect capital, proactively positioning portfolios has been key. International exposure and dividend yields offer attractive opportunities..
A ‘Grexit’ on its way?
All eyes once again are focused on Greece. An inability to form a government has led to a renewed fear that the country could exit the Euro and the wider European Union. Although only a small contributor to European economic output as a whole, contagion is the real risk. Concerns of further losses for external holders of Greek debt and a more widespread break-up of the euro have driven equity market weakness.
A self-perpetuating situation, investors are demanding more to lend to the likes of Spain and Portugal, driving their debt burdens to unsustainable levels. Furthermore, disappointing data from the US and China over the last few days have further added to the uncertainty.
…but preparations are underway
However, preparations have already begun to protect shareholder interest. German and French banks, which were the largest holders of Greek debt, have been aggressively reducing their positions. Some, for example, have cut periphery debt exposure by as much as half since 2010. Banks in the UK have been making provisions since at least November when the Financial Services Authority’s top regulator, Andrew Bailey, told banks: “We must not ignore the prospect of the disorderly departure of some countries from the eurozone.”
On the corporate side, interesting anecdotes have highlighted the proactive nature of company management in the face of this turmoil. Last year, for example, Tui, one of Europe’s largest travel companies, was reported to have requested to reserve the right to pay in a new Greek currency should the country exit from the euro. Corporate balance sheets are robust, holding more cash than long term averages, dividend yields and the potential for merger and acquisition activity once the macro outlook starts to improve can offer an attractive upside.
Finally, although wavering slightly, the US still successfully avoided falling back into recession. Keenly aware of both external and internal risks to growth, Chairman of the Federal Reserve, Ben Bernanke has made it clear he is not afraid to utilise further tools to protect economic growth. Especially with an election this year, policy is likely to remain accommodative. With respect to Emerging Markets, despite the recent wobble and an inevitable cooling of economic growth, with an estimated 1 billion of the population to join the consumer class by 2030, the long-term case remains strong.
Proactive portfolio positioning prudent
To protect capital, proactively positioning portfolios has been key. Reducing direct European exposure as Europe’s southern members showed severe signs of economic stress from an asset allocation perspective and via underlying fund managers has proved prudent. Fund managers have been able to maintain a zero weighting to Greece and a substantial underweight to the likes of Portugal and Spain relative to benchmark.
As equity markets reached new highs in the first quarter of this year, the substantial rally in share prices in the face of continued structural problems within the Euro zone, was a sign that the risk of a downward correction had increased in the short term. Caution was of course well-founded. A move to lock-in profits and redeploy capital to alternatives and property for a more attractive risk/return potential and hedge against inflation has been supported.
Assets which will help portfolio performance during these volatile market times are good quality companies with strong balance sheets paying an attractive level of dividends. Furthermore, in times of slow economic growth and persistent inflation, strong franchises with pricing power for protected market share and the ability to pass on increases in supply costs to the customer are very desirable attributes.
International exposure and dividend yields offer attractive opportunities
Looking forward, a resolution of key issues in Europe is required to gain confidence to add to equity exposure. Structural reform, greater fiscal consolidation, a focus on growth and long term support are required for stability in the region. At the same time, with a medium to long-term time horizon, it is more important to focus on the geographical location of a company’s revenue streams than where it is headquartered. Investor overreaction can offer buying opportunities with share price corrections providing attractive, cheaper entry points to high quality firms. Furthermore, the yield from dividends these companies pay out can provide a valuable income stream. With many investors holding back capital, the flow of money back into markets, buying into sell-offs at lower levels, could dampen these downward moves and provide a level of support. Therefore, although volatility could continue and market direction remains difficult to determine, it is possible to navigate the turmoil.
With political pitfalls possible, eyes on Chinese easing, and a flight to quality by investors, policy is driving market direction. This week, the minutes from the latest Federal Reserve meeting will be scoured for signs of further fiscal support. Moreover, the Bank of England’s inflation report will be reviewed for changes to the outlook for growth and inflation. Central bank rhetoric will determine how investors trade. (Watch this as a slide show…)
Political Pitfalls Possible
France’s new President will meet German Chancellor Merkel today with opposing views on the fiscal treaty (see previous post). Furthermore, until a Greek coalition is formed, turmoil there will continue.
Eyes on China Easing
After data disappointed last week, the Bank of China cut the reserve requirement ratio by 50 basis points on Saturday. This is the equivalent to injecting around $64 billion into the banks. Investors remain watchful on Chinese policy, hoping it remains accommodative as the economy cools, to protect global growth.
Flight to Quality
Unsurprisingly, with the climate uncertain, investors have rushed into perceived safe havens. With much money still on the sidelines, a reversal of this trend could provide a hefty boost to markets. Appetite for risk is a crucial current driver.
QE3 Back on the Table?
The Federal Open Market Committee (FOMC) minutes will be scoured for signs of fiscal support. Housing market weakness and elevated unemployment has caused Bernanke to leave the door open for further stimulus. Any indication of inflation easing could put the possibility of QE3 back on the table. Although still unlikely, with elections due this year, the pressure is on for policy to remain accommodative.
A Worse Outlook for UK Inflation and Growth?
The Bank of England’s inflation report will give investors colour on the headwinds for consumption and the economy as a whole, as growth and inflation forecasts may be amended. Plunging purchasing power will keep consumer spending stifled. As rising inflation data calls an end to a 5 month easing trend and continues to surprise on the upside, investors will be watching for an increase in the inflation forecast. Higher energy prices and lending rates have kept the risk to the upside and as we dip back into recession, businesses are unlikely to boost hiring. Investors will therefore focus on whether the growth outlook is downgraded. Headwinds are severe and sentiment remains depressed.
Graph showing the correction in world equity markets over the past week (S&P 500 in white, Eurostoxx 600 in orange, FTSE 100 in yellow); put in context of the substantial upward move year to date. Source: Bloomberg
This week, issues concerning Europe’s firepower, the US consumer and broader economic growth will determine the direction of markets. Inflation, hard-to-beat expectations and political stalemate provide a significant downward risk to market, although upward momentum could always drive them further.
As fuel price inflation dents sentiment in the US, the consumer may be squeezed and figures for income and spending may disappoint. Furthermore, the opportunity for upside surprises in durable goods orders and Q4 GDP growth is limited as forecasted figures are already high.
A two-day meeting of Europe’s finance ministers will be closely watched for signs of an expansion in the firepower of the rescue fund. The deadline to do so draws near and the pressure for progress grows. However, Germany remains staunchly against such a move and, even if achieved, the figure reached may still not be enough.
As the outlook for growth continues to deteriorate, whilst the price for goods and services remain stubbornly high, the risk of stagflation returns. This would be a tough scenario, where policy options tackling one of these issues would only worsen the other. This creates substantial downside risk for stock valuations based on bullish growth forecasts, whilst making it more prudent to invest in price makers able to pass on rising input costs.
Lower growth outlook
The outlook for growth is bleak. The IMF has reduced their forecasted expansion of Europe from 2% to 1.6% and Goldman Sachs swiftly followed suit predicting France and Germany will fall into recession next year, with the EU stagnating. The data looks supportive of this view. German retail sales disappointed expectations, with a contraction of -4.3% in July vs. -0.5% expected. With Europe still our largest trading partner, the effect on the UK could be severe.
Outside the EU, countries aren’t immune. China’s Purchasing Managers Index has fallen below the 50 mark, the line separating expansion from contraction and GDP growth came in at 9.1%, falling from 9.5% and below expectations.
QE increases stagflation fears
In an effort to boost the economy, the Bank of England surprised many commentators by increasing their purchases of UK government bonds, from £200bn to £275bn. However, this is not without its risks. It is not a guaranteed strategy to boost growth and crucially create jobs. Instead, it is more likely to increase inflation.
Taking bonds out of the market and pumping cash in their place only reduces the value and purchasing power of the currency, making goods and services more expensive. Inflation is already above the 2% target set for price stability, hitting a rate of 5.2% at the latest measure this week. In the EU the value jumped to 3% in September, the fastest increase in 3 years and potentially a reason behind their Central Bank’s decision not to cut rates.
Unemployment in stagnating economies is an issue and highlights the threat. Spain is struggling with 1 in every 5 of their people without a job, increasing to 45% of the youth population, and Portugal’s jobless level has reached highs not seen for over two decades. The US’s September figures are stuck at 9.1%, although CPI came in below expectations. Here in the UK the level might ‘only’ be 7.9% but this is still high and stubbornly so, with inflation surprising on the upside.
The stagflation quandary (where stagnation and inflation meet) is that to tackle unemployment and boost growth, interest rates would be cut, however not only are they already low, but that would boost inflation even further. Likewise, to tackle inflation, interest rates might be increased but this would only hurt growth and employment.
A lose-lose situation.
Risk of Stock Downgrades
So what has this meant for stocks? Firstly, there is downside risk to stock valuations. With many valuations based on forecasted growth, downgrades could negatively impact and seem more expensive. Analysts are 10 times more bullish on the growth outlook than economists. Although, always more optimistic, that is twice the historical average.
Secondly, it may be more prudent to invest with those that are price makers not price takers, as well as with a protected demand base, in order to be able to pass on rising costs.
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.
The fear of inflation is heating up as on Wednesday the Bank of England suggested that “there is a good chance” inflation will hit 5% later in the year, far above the target rate of 2%. Elsewhere, on the same day, Chinese inflation figures surprised on the upside. However, is gold an adequate hedge? It can be shown graphically that it is not. Charting the inflation rate (CPI change year on year) against the gold price, we can see that over the past decade the relationship breaks down. Indeed, if the gold price kept up with increases in general price levels, it would be valued at $2,600 an ounce instead of around the $1,500 level. How about if instead of actual inflation, we look at the market’s expectation of inflation? Even in this case, the relationship does not hold. Instead, there are other factors at play. As previously discussed, investors may be more focused on the sustainability of the economic growth rate and allow for some inflation. Inflation alone may not provide sufficient support.
The Gold Price (white) vs. CPI change year-on-year (orange). Source: Bloomberg
A Beneficiary of Risk Aversion
So — could upcoming economic, fiscal or political disappointments sufficiently boost the gold price? Here the case looks stronger. From sovereign debt crises in Europe, to the tragic tsunami in Japan and the turmoil in the Middle East, there has been enough newsflow to stoke fears and flows into gold (a “whopping” $679m of capital was invested in precious metals in one week alone at the beginning of April). Furthermore, a lack of confidence in the dollar further boosted investment for those looking for a more reliable base.
In addition to jewellery demand, central bank purchases may provide much support for gold as we move forward. Russia needs to acquire more than 1,000 tons and China 3,000 tons to have a gold reserve ratio to outstanding currency on parity with the U.S. This is even likely to be an understatement with China stating publicly they would like to acquire at least 6,000 tons and there are unofficial rumors that this may go as high as 10,000 tons.
Remain wary of relying on one driver of returns; it can often be overshadowed by another. Instead build a complete picture and continuously question your base case scenario. Gold is a more complex asset than many give it credit for and as always, it pays to be well diversified.