returns

Banks Slash Jobs but Severe Headwinds Remain

As banks all over the world slash jobs, we ask ourselves – will this produce more streamline firms ready to generate significant profits, or a sign of the poor outlook for the sector? Unfortunately, stifling regulation repressive and a false bubble has driven this move and severe headwinds remain through exposure to struggling economies and substantial funding needs.

The 50 largest banks around the world have announced almost 60,000 job cuts. UBS are laying off 5.3% of their workforce, blaming stricter capital requirements and slowdown in client trading activity; Credit Suisse cutting jobs by 4% to save SFr1bn and Lloyds a whopping 14%.

Restrictive regulation make banks more stable but less profitable

Stricter capital requirements were just the type of new regulatory measures the Chief Executive of Standard Chartered feared at Davos back in January, would “stifle growth”. At this time we saw banks such as Credit Suisse missing earnings targets and downgrade their expectations severely going forward (from above 18% return on equity to 15%, which turned out to still be too high).

UBS has seen costs in their investment banking division soar to 77% of income and net profit fall almost 50% from a year earlier. Stricter capital requirements mean banks have to hold a higher amount of capital in order to honour withdrawals if hit with operating losses. Furthermore, restrictions on bonuses led to increases in fixed salaries and an inflexible cost base.

Backtracking on a false bubble

Job cuts should also be set within the context of occurring after a ‘false bubble’. Post the 2008 financial crisis and bank bankruptcies and proprietary trading layoffs, the fixed income, currency and commodity business of the remaining players boomed as competition dropped. Banks began expanding. UBS’s proposed cuts of 3,500 jobs comes after an expansion of 1,700 to the workforce and incomparable to the 18,500 job losses experienced during the crisis.

Exposure to struggling economies is a key threat

Crucially, these cuts do nothing to solve the biggest problem these banks are struggling with. They have substantial exposure to struggling EU economies. In Germany, bank exposure to the PIIGS (Portugal, Italy, Ireland and Spain) amounts to more than 18% of the countries GDP. Just last month Commerzbank suffered a €760m write-down from holding debt that is unlikely to be repaid, which all but wiped out their entire earnings for the second quarter of the year. Further fuelling fear of the spread of the crisis from periphery to core is that French banks are among the largest holders of Greek debt.

Here in the UK we’re by no means immune. Our banks have £100bn connected to the fate of these periphery economies. RBS, 83% owned by the British taxpayer is so heavily exposed to Greek debt that it has written off £733m so far this year.

Severe funding needs and fear of lending exacerbate the problem

90 EU banks need to roll €5.4tn over the next 24 months. This will be funded at higher rates and with disappearing demand as investors become more wary, exacerbating the problem. In addition these banks need to raise an extra $100bn by the end of the year. An inability to borrow to satisfy current obligations, not withstanding any expansive moves, is a serious obstacle to profit generation. 

Moreover, job cuts do nothing to boost confidence to encourage banks to lend. Just two weeks ago, EU banks deposited €107bn with the European Central Bank overnight than lend to each other. If banks are not even lending to each other, losing out on a valuable opportunity to make money, then how encouraged are we as investors to get involved?


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Gold may Glitter but can it Deliver?

The classic “safe-haven” investment has seen a strong uptrend in its value since the autumn of 2008. Risk aversioninflation fearsfalls in the dollar and demand from the east have all been credited as drivers of this move. But just how supportive are these factors going forward — what is the risk gold could lose its lustre?

A Hedge against Inflation

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.

Demand from the East and Central Banks

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.

A bubble with no clear end

George Soros described gold as the “ultimate asset bubble” and with sentiment driving the price as much as fundamentals, it’s unclear when the trend will reverse. An increasing monetary base is looking for a home. As Marcus Grubb, MD of Investment at the World Gold Council was quoted as saying at a ‘WealthBriefing’ Breakfast on Thursday: “In the next 10 minutes the world’s gold producers will mine $3m of gold, while the US prints $15m.” However, an often-overlooked drawback in investing in gold is its lack of yield. With some stock offering attractive dividend yields and investors wanting their investments to provide attractive returns during the life of their investment, capital flows may wander.

The Investment Insight

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.


The Problems of “Absolute Returns”

“How often misused words generate misleading thoughts.”   Herbert Spencer (British social Philosopher, 1820-1903)

When it comes to discussing hedge funds, the quote above rings true. Mis-sold and mis-understood, investors have been left disillusioned. Marketed as being able to generate “absolute returns” in all environments, and tarred allwith the same brush in a “one size fits all” sell, appropriateness was often overlooked. All the catchy phrases and vague promises have mis-managed investor expectation and clients spoke with their feet. As we look to the future, with the next generation of “more highly regulated funds”, we must be wary to not fall foul of over-promising and under-delivering…

Common Misconceptions:

1. “Shorts” as a means of risk-reduction to balance “long” exposure vs. ability of funds to be hurt on both the long and short side together due to e.g. unexpected deal surprises. For example, in late October 2008 hedge funds lost £18bn in two days of trading due to a costly short call. Managers had bet on VW shares falling because of the global economic downturn but once Porsche revealed they had been secretly building their stake to a controlling share, they scrambled to cover their positions.

2. If so-and-so are investing, then sufficient due diligence must have been carried out”. Just take the Madoff ponzi scheme – half of UBP’s 22 fund of funds invested, HSBC provided finance to clients who invested, many successful individuals invested large amounts…. It comes back to the basic tenet – “Never invest in a business you cannot understand “ (Buffett)

3.  If I get nervous, I can always take my money out. Following on from point 2, without investigating a fund – the liquidity of its underlying investments, the commitment of major shareholders etc., many were shocked when fund of funds, in particular, implemented side-pockets and gates to limit the amount a client could redeem.

4.  “Larger funds are always safer” In actual fact it was many of the larger funds that found it hard to meet redemptions – needing to liquidate a larger amount in the market and slower to implement changes in strategy as markets sold off back in 08. Instead it was the smaller, more nimble players that were able to adapt quicker to navigate the markets better, and able to meet redemption requests more easily and avoid having to implement side-pockets or gates.

5. “Paying an extra layer of fees is worth the diversification benefits of a fund of funds investment – although still true in some instances, many fund of funds are merely “best of breed” funds with less emphasis on portfolio construction and therefore less of an uncorrelated nature. In addition, those that paid less attention to the liquidity of their underlying funds were squeezed when these funds gated whilst they were receiving redemption calls.

What can we do with this information?

1. More accurately assess the risk profile of a hedge fund investment, size and position allocations accordingly

2. Ensure a full due diligence process has been carried out

3. Assess the liquidity of the assets the fund is investing in and interview large fund shareholders – a managed account is not always necessary, the emphasis should be on appropriateness – daily liquidity is suitable for a large-cap global equity fund but a more private equity-type fund could suffer from too much focus on managing flows than managing the money itself.

4. Look for the sweet spot that exists at the point when a fund’s running costs are comfortably covered and there are low operational concerns, whilst the manager still has the hunger to perform before becoming complacent and managing more than he is best at handling.

5. Watch the correlation of the fund to other parts of your portfolio and to the managers within the same asset class to ensure sufficient diversification benefits – mitigating some of the volatility for steadier returns.

MANAGE CLIENT EXPECTATIONS