After disappointing economic growth within the UK fed fears of a ‘triple-dip’ recession, housing market data has added fuel to the fire. Stability is needed for consumers to feel more confident and comfortable spending but instead contraction continues. Outside of London and within the prime real estate market, demand has been driven by a low level of supply and foreign investment. However, outside of this insulated area, property is struggling and banks still have assets to offload which could further maintain downward pressure on prices.
From accusations of interest rate manipulation, to charges of illegally hiding transactions with Iran, the spotlight is well and truly on the banking industry. Institutions appear to have been operating right at the edge of what’s reasonable where the line between right and wrong can become blurred. Crucially, it highlights how issues can occur outside ‘investment banking’, and therefore attempts to classify one part of the industry as bad and one part good is flawed. Nevertheless, public opinion is against the banks and it’s up to them to earn back respect. We’re entering a tough new paradigm of tighter regulation, greater demands for transparency and less incentive to lend. Vindication, conviction and takeovers are all possible but one thing we can be more certain of, the regulator is watching closely and further turmoil is likely.
Working On The Border Between What’s Right And Wrong
Standard Chartered has been accused of illegally hiding transactions with Iran. The aggressive attack of money laundering charges came as a shock to investors, who punished the bank’s shares with a sell-off of more than 16%, wiping $6bn from its market value. So what can we take away from this latest scandal? Is this a one-off or an indication of an industry wide shortfall?
However therein lies the shortfall, the opaqueness. Investors maintain these discussions should have been better highlighted in their last annual results. The confusion surrounding whether they did or did not do wrong may signal that they could have been operating right at the edge of what’s reasonable.
With a focus on profits and market share, the line between right and wrong can become blurred. Indeed previous fines have merely moved not mitigated risk. As other banks closed their doors on these types of transactions, Standard Chartered, it has been argued, may have instead welcomed the new business. Changing this culture may prove prudent.
Issues Aren’t Black & White But Murkier ‘Shades Of Grey’
An interesting aspect of this investigation is the type of bank business it is targeting. This is not an investment banking scandal. Instead commercial banking dealings are under attack. Could this have been avoided by having investment banking and retail banking separated? Arguably no. It is not as binary as one part good, one part bad and not all banks overall are the same as each other either.
Indeed, investment banking can help subsidise the cost for running other banking operations and although transgressions may have been made, not all who work in the industry can be tarred with the same brush.
A New Paradigm
There is huge political capital in ‘bank bashing’, finding a common ‘enemy’ to engender sympathy and support. But the pressure is on the banks to earn back trust. Likewise, whilst banks have to get used to tougher regulation, we must accept that fines could erode their reserves and reduce their incentive to lend. A tougher ‘new paradigm’. Furthermore, whilst financial institutions must accept greater demand for transparency, both banks and regulators must improve the way they communicate with the public to avoid unnecessary panic.
Vindication? Conviction? Takeover? Next Wednesday we’ll hear Standard Charter’s response to these accusations. Analysts admit that at this stage it’s hard to know which way the case will go. An unintended consequence could be a potential takeover, with JP Morgan already mentioned as a possible buyer (source: John Kirk at Redburn). As some hope to split banks up so they are easier to control, this would not be a welcomed outcome. Meanwhile the LIBOR scandal continues as additional institutions are investigated. Further turmoil is likely. And the regulator is watching…
Inflation, hard-to-beat expectations and political stalemate provide a significant downward risk to market this week. (Quoted in the Weekend edition of the Financial Times)
Last week was dominated by disappointing manufacturing data from Europe and China, whilst markets shrugged off a less than impressive Budget. After such a substantial rally year to date, this correction is healthy.
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 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?
The deadline for delivering a deal to allow the US to continue to borrow and spend, August 2nd, is approaching. Mirroring issues in the EU, a problem of debt cannot be solved by yet more debt. With the threat of a downgrade looming, any rise in interest rates could make the situation worse, hitting the tax payer and US exporters. Moreover, an increase in this ‘benchmark’ rate could impact the UK and hurt our property market, and a weaker dollar could result in job losses in our export sector. Further afield, with China the largest holder of US debt, the concern could spread globally towards countries relied upon to drive future growth. But failing to raise the ceiling isn’t an option and may cause an eventual default further down the line. Therefore, a deal will be struck and a balance found between demands for more spending cuts and aspirations for tax increases.
The US has ‘maxed out its credit card’
The US debt ‘ceiling’ is the maximum amount of bonds the US can issue, i.e. the maximum amount the US can borrow to finance its spending. The limit is currently set at $14.3tn but with the country spending approximately $120bn more than it takes in terms of revenue each month, after funding its participation in 2 world wars, rescuing the financial system post-Lehmans and pumping the economy with new capital to boost economic growth, the debt limit was reached on May 16. Put another way, the US has maxed out its credit card.
The issue echoes EU troubles: Debt cannot solve the problem of debt
Instigated in 1917, the debt ceiling has in fact been raised 74 times since 1962 alone. It should be noted; raising the limit does not increase fiscal spending but merely allows current obligations to be met and annual deficits to be financed. Nevertheless, in the current environment, with sovereign debt crises in Europe, investors and rating agencies are becoming acutely aware that cannot solve a problem of debt with more debt and the extent to which the ceiling would have to be expanded is troublesome. Obama’s proposed budget will require a ~$2.2tn hike just to meet next year’s obligations.
A lose-lose situation could hit tax payers and US exporters
Even if the ceiling is raised, there are other issues to tackle. S&P in April threatened reduce the credit rating of US debt. The importance of this threat should not be underestimated. With a ‘AAA’ status and ‘stable’ outlook’, any downgrade would threaten its role as the safest place to store savings. To retain their position, the US needs to address how it will not only plug this short-term gap, but also meet longer-term challenges. A hit to confidence would increase the rate of interest demanded by investors to compensate for a higher perceived risk of loss. This would increase borrowing costs for the US, worsening their debt burden and further limiting the amount of new debt they would be able to issue. It has been estimated that even an increase of 25 basis points could cost tax payers $500m more per month. With less demand for US treasuries, there would be less demand for the dollar to fund these transactions, making the products the country exports more expensive abroad and again hitting their balance sheet.
The issue could hit the East and future global growth
In its extreme, uncertainty could spark another financial crisis as well as put the dollar’s status as the world reserve currency at risk. (Interestingly, a McKinsey investigation reported less than 20% of business executives expect its dominance to continue to 2025). For this isn’t an isolated incidence. Dollar-denominated US debt is held world-wide (especially $1.1tn by China), spreading the problem towards the very countries many are lauding as growth drivers of the future.
UK jobs, home prices and recovery could be hit
There could be dire consequences felt even in the UK. The US is our largest export partner, spending $50bn for our products last year alone. A weaker dollar would damage American buying power, making these products more expensive and damaging demand. This would cause companies producing these goods to suffer and jobs would be lost. Furthermore, if fears over the ability of the US government to repay its debts led to investors demanding more to lend to the UK government, mortgage rates would become more onerous and it could be harder for buyers to purchase a property. With less investors able to buy and therefore lower demand, sellers may be forced to lower asking prices to get a sale.
Failing to raise the ceiling wouldn’t cause an immediate but an eventual default
In the near-term, the US could continue to function. Failing to be able to increase borrowing would necessitate spending cuts: to military salaries, social security, medicare and unemployment benefits. Furthermore, some of their debt could be rolled over so long as the overall amount of treasuries outstanding didn’t rise. However, this is unsustainable in the medium to longer-term and would lead to an eventual default.
With too much at stake a deal is likely to be reached
The issue is currently being used as a negotiating chip by Republicans to get deeper cuts and long-term reforms whilst refusing to raise taxes, versus the White House aiming to cap tax exemptions and reduce ‘inequalities’ benefitting big business. Nevertheless, with such serious ramifications possible, it is unlikely a deal will not be struck.
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.
Join Guy Johnson and Louisa Bojesen for a fast-paced, dynamic wrap up to the trading day. “European Closing Bell” gives an in-depth analysis of the day’s market action and includes expert analysis from the major players in the European business and financial world.
Billed as the “most pro-growth budget for a generation”, attacked with the claim the “hurting isn’t working”…
In a growth-starved environment, with inflation figures stoking fears, today’s budget was awaited in eager anticipation. Aiming to simplify our complex tax system, increase competitiveness and boost domestic industry, the politically astute rhetoric rang loud while bottom-line impacts remained mixed. Most crucially as an investor, how has the budget impacted the outlook for investment?
Growth Alone does not Drive Equity Returns
Much noise has been made over the downgrade of this year’s growth forecast (from 2.1% to 1.7%) but studies carried out to investigate a link between growth and equity returns have come back empty handed. Taking the recession during the early 1990s as an example, during its duration the UK All Share Index increased in value by more than 16%. Furthermore, as I write this article, the FTSE 100 is barely reacting.
Outlook for Stock Pickers Remains Buoyant
The government has picked certain sectors for penalty, others for promotion and the budget will impact companies in different ways. Investors and fund managers able to differentiate and exploit this will be well-placed. The following bullet points give a high level overview highlighting some of the discrepancies:
- TOBACCO duty to rise by 2% above inflation,
- BANKS to not benefit from corporate tax cuts,
- OIL companies to fund the ‘fair fuel stabiliser’,
- SMALL R&D heavy companies will benefit from a 200% tax credit this year,
- private AVIATION hit with a levy,
- home CONSTRUCTION firms to benefit from first-time buyer incentives focused on new builds
In addition, Illogical moves may reverse. Consumption remains under pressure (unemployment still near record high levels) but the outperformance of consumer discretionary over consumer staples has reached almost 50% – illogical since spend on luxury goods should be hit the most. Therefore, there are opportunities for high quality companies with pricing power and strong demand for their goods to play catch up.
Diversifying into Other Currencies Supported
In reference to the recent tsunami in Japan, the Chancellor mentioned the support the UK has provided and, in doing so, confirmed the UK’s aim of building foreign asset reserves. With countries artificially pushing the value of their currencies down (read: Brazil’s $40bn intervention last year and Chile’s $12bn this year) and others keeping theirs low (read: China’s RMB believed to be 40% undervalued), the upside potential when this eventually ends is great. Stan Fischer, the Governor of the Bank of Israel revealed they “are diversifying into currencies which (they) would never have put in the reserves before”, supported by the Governor of the Bank of Canada with his belief that we will see a “multi-polar” system. Watching sterling’s moves today, the currency is off slightly against the dollar but the real moves will be versus emerging market currencies and over the longer term. Following the lead of Central Banks ‘spreading their wealth’, this form of diversification may be prudent.
Promotion of Alternative Schemes
The tax relief on EIS (Enterprise Investment Schemes) and VCT (Venture Capital Trust) investment will be increased from 20% to 30% next year, offering a substantial opportunity for tax efficient investing. More interesting and less noted is the move to allow larger companies to be eligible for the scheme. This has been claimed to reduce risk. To this, a footnote should be added. Lower risk opportunities may be available but the same level of due diligence is required.
Finally, although not strictly an investment, giving to charity now has financial benefits in addition to goodwill. Those who donate may be granted a 10% discount in their inheritance tax bill. Looks like the government may be targeting not just our wallets but our souls.
“We cannot forget how in 1997-98 American hedge funds destroyed the economies of poor countries by manipulating their national currencies.” – Dr. Mahathir Bin Mohamad, (former Prime Minister of Malaysia, during the emerging market crisis).
The Hedge Fund industry has come under major scrutiny in the past few years. Blamed for stock market crashes, manipulating the markets and threatened with a ban on short selling, if a scapegoat was needed, they were ‘shortly’ targeted (!). Chargers of high fees and notoriously opaque – people naturally fear the unknown, and an expensive unknown even more so. Nevertheless, as Richard Wilson pointed out in his blog – back in 2007 the head of the Financial Services Authority (FSA) said that:
“hedge funds were not the catalysts or drivers of (that) summer’s events.”
Hedge funds trading in the financial markets can increase liquidity and aid price formation. Jed Emerson wrote a great piece at the end of last year taking he argument away from a debate between “good” and “evil” and instead concluding:
“fundamental fund of hedge fund investment strategies, when managed appropriately, may represent an emerging though as yet not realised opportunity for investors to pursue both full, commercial rate returns and affirm relevant aspects of Sustainable investment practice.”
Although I question the assertion the fund of hedge funds industry is emerging – since in some cases it seems to be retracting, I agree they offer an opportunity for returns and the claim of affirming sustainable investment practice balances the opposition’s argument.
What seems to be a rarely discussed topic is the value the industry provides the wider economy, outside the financial markets. Below I highlight some impressive information, sourced from a great article by Open Europe….
BOTTOM LINE: Job and tax contributions should not be under-estimated.
Benefits of PE / HF Industry to EU Economy
- Contributed ~ €9 billion (£7.9 billion) in tax revenues in 2008 – could fund the EU’s overseas aid budget for twelve years, or the regional budget for Poland,
- Directly employ 40,000 people in the EU – 18,000 of whom are employed in the UK (before taking those involved in real estate funds or dependent on the industry)
Benefits to UK Economy
- €6.1 / £5.3 billion tax income raised in the UK alone
- Enough to pay for over 200,000 nurses or 165,000 teachers.
- Tax revenues generated over 2 years could pay for the entire 2012 London Olympics.
- If the revenues were lost, would take 20% increase in av. council tax bill to make up
Back from a business trip to South Africa. I was flown over to present my investment ideas and during my time being the key note speaker and from the conversations with investors, I noted a recurring question – “what data should I watch?”. Now I always maintain one must not focus too heavily on one data point or information from one source / point of view. Nevertheless, to help give some clarity, I’ve managed to boil down global economic insights into just a handful of key points. Starting with the UK… Short term growth restrained, drivers of growth later on uncertain…
In terms of the three stages required for a self-sustaining recovery…
1. Stimulus – yes, we’ve seen quantitative easing but are we seeing LENDING (to businesses, consumers etc – remember consumption still accounts for a large % of GDP)?
2. Inventory Rebuilding – yes we’ve seen temporary re-stocking but are we seeing consumers SPENDING?
3. Job Creation – are jobs no longer at risk i.e. a SELF-SUSTAINING recovery?
Conclusion: The UK “aint there yet!”
1. Versus stimulus we are to see – THE LARGEST FISCAL SQUEEZE SINCE WW2…
And lending remains muted:
“Despite various forms of support from the Bank of England and from Government, it is clear that the lending capacity of the banking system, in the UK and elsewhere, is impaired and will take some years yet to recover. Some banks need to continue de-risking and de-leveraging.” Paul Fisher – Executive Director Markets and member of the Monetary Policy Committee
2. Instead of spending, governments, households and companies are DE-LEVERAGING, CONFIDENCE IS LOW, household spending restrained
In Rebecca Wilder’s article in her blog Household leverage: what does the US have that the UK does not? in News N Economics (her answer: they still have expansionary fiscal policy) the chart featured below highlights the extent to which households still need to de-lever (and a comparison of the heightened problem in the UK vs. the US)
3. Job creation? Following on from the government’s public spending review – 750k public sector jobs are at risk
INVESTMENT INSIGHT – Conditions for a sustainable, strong recovery are “still not there yet”
Returns are to be generated opportunistically – in a lower growth environment, index moves may be range bound – capture alpha from the volatility – quality stocks that are over-punished during pullbacks. Instead of investing in companies focusing on UK sales, invest in those more internationally focused (especially EM).
Stock example – RR/ LN: Rolls Royce Group PLC (more on the car manufacturer next), the global power systems company, “signs agreement with STX Engine Company to further strengthen position in Asia” October 2010 (Rolls Royce Announcement)
“STX Engine, based in Korea, will become a packager of Rolls-Royce industrial gas turbine generating sets in the Asia Pacific region to better serve the growing demand for electrical power generation technology and will further strengthen our position in important Asian markets such as Bangladesh, Philippines, Taiwan, Vietnam and also Korea”.