Wealth and Investment Management Blog

Climbing without protection

Posted on January 18, 2013 by Wealth and Investment Management

“No mountain is worth dying for” – attributed to Walter Bonatti

Stocks have outpaced other assets – including high yield credit – by more than enough to compensate for their higher risk. The S&P 500 is within 5% of its October 2007 summit, and pundits are talking (again) of investor complacency. Should we worry?

In a trading context, markets look ‘overbought’. After rallying by 13% from November’s pull-back, the chart of the main Continental European index looks a little exponential: some vertigo is understandable. Profit-taking would not be surprising, and there are some obvious potential triggers. For example, the US government may not be able to meet its bills from around mid-February; the Italian elections in late February could break the market truce over the euro crisis (and some euro officials have been sounding a little complacent); geopolitical risk is still very visible, most recently in the tragic events unfolding in Algeria.

For investors who are in the market and nervous, but don’t want to close their positions, the cost of portfolio protection is relatively low. The so-called ‘fear index’, the VIX, has been trading at its lowest levels since 2007. But no-one likes buying insurance, and we doubt it is worthwhile now for investors with moderate risk appetites and composure. And we would advise caution in actively trading volatility itself. It has been in a bear market since early 2009 – a point missed by many, but really not surprising given the wall of cheap insurance implicitly written by central banks. When the VIX rises these days, it spikes. Blink, and you’ve missed your turn.

In a longer-term context, and after allowing for inflation, stock prices don’t look so exposed. Taking corporate profitability into account, valuations seem undemanding (and the results season in the US is not suggesting that our expectations there are too high – if anything, rather the opposite). We’d view a market setback as an opportunity to add to positions.

Most investors are not complacent, but are still concerned at the ability of the global economy to grow in the face of its many headwinds. The questions we receive focus almost unanimously on what could go wrong for consumers, companies, and currencies, and the articles and third-party research that we’re asked to comment on do the same. More objectively, the 10-year US Treasury yield remains below 2%: the largest bond market in the world is telling us loudly that investors remain more confident in disinflation and crisis than in those storm clouds lifting.

Postscript: The UK’s evolving relationship with the EU is sparking interest (there is a keynote speech from the PM pending). Leaving the EU would likely be moderately bad for business. The UK needs easy access to the (almost) single EU market (in goods, services, labour and capital). It’s the sort of thing that could affect the UK’s structural growth rate – maybe trim it by a decimal point or two – and damp sterling. That said, it would not be catastrophic – Switzerland manages reasonably well – and we judge the likelihood of leaving to be low. Just as the UK government is sounding determined to offer voters a choice on the topic, a formally two-speed EU is looking more likely. Markets are urging the eurozone to press on with deeper integration, making it easier perhaps for the rest to drag their feet while staying within the single market. If such an outcome were acceptable to UK voters, it could leave the economic outlook effectively unaltered. Of course, in the last resort, the EU is a political project, not an economic one….

Kevin Gardiner, Head of Investment Strategy EMEA

Filed under: Equity market volatility, Equity markets, UK, US | 1 Comment »

Business – and ownership – first

Posted on January 11, 2013 by Wealth and Investment Management

We have noted that while the clouds in the investment sky are not about to disappear, we do expect them to lift a little further in 2013. Strategically and tactically we translate this central theme into practical portfolio advice by favouring (1) corporate over government securities; and (2) stocks over bonds.

(1) Companies preferred to governments. This is not driven by creditworthiness: we doubt any large government will come close to default. Deficits are falling, and governments’ monopoly of taxation and coercion rights gives them the last word in any solvency debate.

Instead, the business cycle matters more than government deficits (or even quantitative easing, ‘QE’) in driving bond prices. The same economic growth that is helping trim deficits will lead eventually to expectations of higher interest rates (and an end to central bank buying). With most high-quality government bond yields still at very low levels, this leaves them vulnerable. They remain the most expensive asset class, even after the New Year sell-off.

We don’t think government bonds are in a ‘bubble’: par values will be respected, and the potential mark-to-market losses are not comparable with the end of – for example – dot.com dottiness or CDO craziness. And calling the precise date at which the 30-year bull market becomes a bear is not easy. But the plausible strategic returns from a fixed-coupon asset yielding less than central banks’ inflation targets (let alone inflation itself) are negligible.

Corporate bonds are not cheap either: investment grade credit is the second most expensive asset. But yields are higher, and duration a bit lower, making them a little more stable in the generally company-friendly climate that we expect. Speculative grade bonds, which performed very strongly in 2012, still yield around 6% on both sides of the Atlantic, which – allowing for plausible loss ratios – makes them still the most attractive fixed income asset.

(2) Stocks preferred to bonds. We’d rather own business than lend to it. This is true in public markets at least, although some private loans may be more attractive. A material fall in profitability seems unlikely. Stocks are of course the most volatile asset, reflecting that ownership risk, but they remain the least expensive, even after their recent rally, and allowing for analysts being a bit too optimistic, as usual, about near-term profits. They may also benefit from a modest releveraging of non-financial balance sheets if business confidence stabilises and accumulated cash is put to work (in capital spending, stock buy-backs, dividend increases, and M&A activity).

The ‘cult of the equity’ arguably ended more than a decade ago. Institutional weightings have fallen a long way. Accounting rules make it difficult for defined-benefit pension schemes, and many Continental life assurers, to hold them (perversely, since an undated stock’s growing cashflow makes it the longest-duration asset and a natural hedge for many long-term liabilities). This is not likely to change soon. Meanwhile, some private investors may never sell their bonds – having seen those bonds protect and grow their capital in some testing times, they may already have decided, understandably, to hold them to maturity, pending mark-to-market volatility notwithstanding. Talk of a “Great Rotation” out of bonds and back into stocks looks a little premature, then. But stocks have clawed back some of the last decade’s poor performance without one, and can continue to do so.

Kevin Gardiner, Head of Investment Strategy EMEA

Filed under: Economics, Equity markets, GDP | 2 Comments »

The main theme

Posted on January 4, 2013 by Wealth and Investment Management

“Keep your eyes on the road, your hands upon the wheel” – Jim Morrison

Happy New Year! Stocks have certainly been celebrating as the immediate risk from the ‘fiscal cliff’ has been defused. Despite the brinkmanship, congressional majorities for a compromise on taxes were sizeable – perhaps the US political system is not quite as frozen as feared.

Risks remain of course: some difficult decisions have simply been postponed (again). Public spending could yet be sequestered; the debt ceiling still has to be lifted. March is a key month. The deficit, however, is falling steadily, and if the economy has momentum, negotiations may be easier (a little growth clearly goes a long way). We’ve long expected only one-third of the potential 2013 fiscal hit to materialise – a headwind, not a brick wall (or cliff…). Longer term, the US could raise its national tax rate by one-fifth and still be a low-tax economy.

In the eurozone, no news has been good news over the holiday period as politicians have been remarkably quiet. This has allowed markets to ruminate on that conditional promise of ECB support, and on more signs of stability in business surveys. Spain’s 10-year bond yield has fallen again, even as bunds have sold off with Treasuries and gilts: it is below 5% as we write (the spread to bunds is at a 9-month low, almost 300bp lower than July’s peak).

That sell-off in core bonds could prove one of the most significant developments this New Year: the US 10-year yield has pushed above its 8-month trading range, but at just 1.9% the bond is still of course expensive. The problem is that these holiday markets are thin – evident perhaps in the narrow dispersion of returns within asset classes – and we’ve lost count of the number of recent New Years in which the end of the Great Bull Market in bonds has been proclaimed prematurely. Groundhog Day isn’t as funny on a second viewing.

So we wouldn’t be rash enough to suggest that this performance will continue in a straight line through 2013. But tactically we do favour corporate to government securities, and stocks to most bonds and cash (see table overleaf). For investors whose risk appetite and financial circumstances permit, and who are not already so invested, we advise using setbacks in stocks, or rallies in bonds, as an opportunity to put these views to work.

The outlook for global growth is probably less fragile than feared. Corporate profitability is unlikely to fall materially. The ECB will likely succeed in backstopping the euro (though it is not our favourite currency). More strategically, valuations still point to above-normal returns from stocks, and below-normal returns from bonds and cash, in the years ahead.

This pro-risk stance is our main investment theme. There are lots of subsidiary themes out there, and some of those can seem more engaging, particularly in these chastened times for macro analysis. But to focus on trees currently is to risk missing the forest. Some seemingly obvious themes (demographics?) are likely long-since priced-in. Others may be mistaken (peak oil?). And the more moving parts there are, the more hostages to fortune there are too.

If we had to pick a contrarian side bet, it might focus on the Fed’s significant – and arguably misinterpreted – announcement before Christmas that it is swapping its calendar-based monetary guidance for explicit economic targets. Today’s data remind us that its 6.5% unemployment objective may be a little closer to hand than money markets think…

Kevin Gardiner, Head of Investment Strategy EMEA

Filed under: Economics, EU, UK, US | Leave a Comment »

A time and a place

Posted on December 10, 2012 by Wealth and Investment Management

“We used to think that you could spend your way out of a recession, and increase employment by cutting taxes and boosting Government spending. I tell you in all candour that that option no longer exists, and that in so far as it ever did exist, it only worked… by injecting a bigger dose of inflation… followed by a higher level of unemployment… ” – James Callaghan, Blackpool 1976

This week’s quote often used to feature in undergraduate exams. A Labour Prime Minister – who didn’t go to university because he couldn’t afford to – was rejecting Keynesian orthodoxy and experimenting with monetarism. It resonates today not just in the UK, where this week’s Autumn Statement has reignited debate about the austerity programme, but globally.

Government deficits across most of the developed world widened sharply after 2007 as ‘automatic stabilisers’ and discretionary support muted the damage done by the financial crisis. Overnight, the world was Keynesian again, and few economists would have had it differently. Any attempt to fill the gap left by paralysed – or liquidity-starved – private spending was welcome, and government balance sheets were not stretched at the time.

Difficulties can arise when the extra spending becomes routine, and extends beyond the emergency phase. Historically, this is what Callaghan was referring to in a UK context (and in those days deficits were supposed to be mostly funded – that is, they were not largely financed by the modern-day printing of money, but by the sale of gilts to the non-bank private sector).

In the last resort, the potency of much government spending – and money printing – relies on the private sector not thinking too carefully about where the resources are coming from. The legacy of the monetarist revolution was not a fixation with money supplies but a greater focus on the supply-side of the economy – companies and the goods and services they produce – and on the important role played in economic life by expectations. Perhaps one of the reasons ‘QE’ has been less potent than it might have been is the fact it has been so visible. When central banks tell us that they are printing money, we expect inflation, not growth, and act accordingly.

Of course, too rapid a withdrawal of government from aggregate demand can be counter-productive. In the US, that fiscal cliff is unnerving all but the most fanatical libertarians. But if the private sector is running a financial surplus – as it is currently, on both sides of the Atlantic – and the monetary climate (defined conventionally) is supportive, fiscal retrenchment and even the eventual unwinding of QE can be managed without pushing economies into reverse gear.

So the fiscally-austere climate in the developed world does not in our view doom us to a growth-less 2013. Incoming data continues to suggest that private sector confidence and spending has some momentum in the US, and is slowly stabilizing in Europe. In an underlying sense, growth comes from innovation, and the availability of labour and other inputs. We think that inexpensive corporate securities, particularly developed stocks and high-yield credit, have the tactical and strategic edge over government bonds, even as those deficits fall.

As this is the last ‘In Focus’ of 2012, we wish readers a happy Christmas and a peaceful and prosperous New Year.

Kevin Gardiner, Head of Investment Strategy EMEA

Filed under: asset allocation, debt ceiling, EU, fiscal tightening, household income, monetary policy, Trade deficit, UK, US | 1 Comment »

The ‘new normal’ is getting old

Posted on November 30, 2012 by Wealth and Investment Management

“I have to admit it’s getting better” – Lennon/McCartney

And so we move into the final month of another testing year… Yet despite the twists and turns surrounding eurozone integration, the US fiscal outlook and the slowdown in China, 2012 has not lived up to its disaster-movie billing (not that we expected it to). Barclays’ Strategic Asset Allocation is up by an estimated 9% year-to-date in dollars (at the moderate risk level). This is somewhat higher than we envisage in a typical year, and all nine asset classes have delivered positive returns. The VIX, the so-called ‘fear index’, has actually fallen by a third as central banks have effectively written a lot of cheap systemic insurance, reducing the cost of portfolio protection.

Of course, the year has not closed yet. Negotiations around the US fiscal cliff continue and the Spanish government is still facing down the bond vigilantes. Renewed market noise would be no surprise. But we approach 2013 feeling a little more confident in our long-standing ‘muddle through’ scenario. The sound-bite has served us well, and if we quietly drop it in the New Year it will be because we’d simply like a fresh metaphor – as no doubt would many of you!

We think the US economy will avoid stalling in 2013. Growth may slow a bit, since – even with a compromise on the cliff (which we expect) – there will still be a fiscal headwind (perhaps around one-third of the hit that looms if a compromise is not achieved). But the US consumer is in better financial shape than is generally realised, and increasingly confident with it. This is visible not just in survey data but in the reviving housing market.

A 2013 growth rate of 2% would actually be slightly faster than the recent trend. Few commentators realise that the decade to 2010 was the worst in half a century for US GDP growth: the economy in the new decade is likely accelerating a little. Even if it didn’t, the ‘new normal’ – low growth forever – is surely long since baked into most asset valuations.

In Europe, the latest rally in Spanish government bonds is a reminder that Spain may avoid asking for a formal bail-out. As we’ve noted here before, the key thing is the credibility of that ECB promise to help if asked: if markets believe it, they may not push Spain to activate it. Spain’s economy will not revive quickly, but it is on track fiscally and may be ahead of some of its senior peers (France for example) in supply-side reform. Meanwhile, wider eurozone economic surveys show some stabilisation – GDP may not be far behind.

Kevin Gardiner, Head of Investment Strategy EMEA

Filed under: commodities, Economics, Equity markets, fiscal tightening, GDP, Greek debt, UK, US | Leave a Comment »

Just another BRIC in a fall?

Posted on November 23, 2012 by Wealth and Investment Management

“Too early to say” – Zhou Enlai, thought (mistakenly) to be talking about the French Revolution

MSCI China, even after its recent rally, and including the strengthening renminbi, has lagged developed stock markets by 19% in the last two years, and 10% in the last five. Is China just another over-hyped emerging market?

We think not. China’s ongoing liberalisation and economic growth remains one of our favourite long-term investment themes. While it can be played profitably indirectly – through the shares and bonds of companies quoted elsewhere whose businesses are influenced by China – we think some direct holdings in the market should be in most long-term investment portfolios.

MSCI China has actually fared materially better than the high-profile BRIC quartet overall, which has lagged developed markets by 17% in common currency terms in the last five years. This largely reflects China’s stronger currency – but that appreciation is itself a reminder of one of China’s structural advantages, in our view.

This is not to say that the China story is free of hype. Rapid GDP growth excites economists, but doesn’t guarantee good returns. On average, China’s GDP has outpaced America’s by 7% per annum since 1992, but its stocks have lagged by 8% per annum in common currency terms. GDP growth doesn’t always materialise in quoted sector profits, for all sorts of reasons – capacity is not always driven by profitability, and the state can interfere in price-setting. Most recently, of course, GDP growth has slowed, and China has shared in the profit downgrades common to most stock markets. Meanwhile, the state owns controlling stakes in most quoted companies, leaving a massive overhang of issuance to be worked through, reflected in the continuing slide in the main onshore markets, or A-shares.

However, a structural growth rate of around 7-8% must at least help: the People’s Congress confirms that economic reform and liberalisation remain priorities. Massive currency reserves ($3 trillion), and a current account surplus, suggest some financial stability. The cyclical slowdown is moderating, and profit expectations with it. And MSCI China now has a plausible single-digit prospective PE, well below both the rest of emerging Asia and its 10-year history.

There is of course the unresolved issue of political change. A case of “too early to say”, indeed. But in the meantime, perspectives differ: since Plato we’ve known that democracy and meritocracy – two positive ideas for most of us – can conflict. Defenders of China’s governance argue that efficiency matters most: the urgent need is for infrastructure and higher living standards. We may not agree, or even accept that China’s society is more meritocratic, but in some clearly defined areas the West can act similarly – in running businesses, for example.

We would not recommend playing the long-term China theme through Chinese stocks only. Asia generally is our preferred emerging market bloc, and markets such as South Korea and Taiwan offer some exposure to China’s growth – as, of course, do many Western companies (which look equally inexpensive). But MSCI China looks relatively attractive as we enter 2013.

Elsewhere, we continue to expect an eventual compromise on the ‘fiscal cliff’, and the ECB to backstop the ongoing euro crisis (tensions in Greece and Spain, and France’s downgrade, notwithstanding). The global investment glass remains half full.

Kevin Gardiner, Head of Investment Strategy EMEA

Filed under: Economics, GDP, ECB, EU, Greek debt | Leave a Comment »

Meanwhile, back at the ranch…

Posted on November 16, 2012 by Wealth and Investment Management

“I don’t want to change the world, I’m not looking for a new England” – Billy Bragg

The US stock market may be 5% lower than it was on 6 November, but what’s really changed as a result of the US election? Very little, in our opinion.

Hurricane Sandy may be obscuring that fact. US retail sales, unemployment claims and industrial output all seem to have suffered some storm damage, unsurprisingly. But we think the US economy, and with it the outlook for global risk assets, continues to move in the right direction. It is happening frustratingly slowly, but things are getting better, not worse.

For sure, the ‘fiscal cliff’ is daunting. However, the chances of a compromise may have risen since 6 November. Our New York-based strategist Hans Olsen suggests that a chastened Republican Party may be willing to compromise a little sooner than we’d thought, and the probability that the fiscal tightening will be limited to just 1-2% of GDP – rather than 4% or so – has strengthened. Surcharges on capital gains and dividends are done deals; but the underlying tax rates – and much of the wider tax base – are not fixed, nor is the extent of spending cuts.

Meanwhile – unnoticed by many – the US government deficit has begun to shrink: from a peak of 10% of GDP in late 2009 it has dipped to 7% in the latest four quarters for which we have data. Economic growth, although lacklustre, has at least supported the tax base.

This growth has also supported profitability. The latest reporting season leaves S&P 500 operating earnings on track for a 2012 outturn of around $100 in index terms, even after a sharp fall in oil-sector income. Analysts’ expectations were as usual nudged lower beforehand, but most institutional investors would have settled for this a year or two back. Valuations remain firmly below relevant trends (even with 2013 forecasts probably still a bit too high).

Of course, the euro crisis continues to rumble on. We are not surprised: this is not the stuff of adventure stories (“With a single bound they were free” is a euro headline that will never be written). Instead it’s likely to resemble a (dull) classical myth: euro politicians seem doomed to toil Sisyphus-like on fiscal and banking integration, and economic reform, forever. But markets need not stay on the edge of their seats in the (considerable) meantime. The ECB has promised to act as backstop, and if that promise is credible it may not matter that much whether Spain formally requests assistance or not. Knowing that the ECB will buy bonds may encourage investors to keep lending. The Spanish economy is qualitatively different from Greece’s, and not just because it is so much bigger. There is an industrial infrastructure – it has recently been making more cars than France, and a lot more than the UK – and its public debt arithmetic is unremarkable. Greece itself can still unsettle markets (though we have been surprised ourselves at the troika’s lenience of late), but likely has much less systemic weight than it used to.

We think US fiscal brinkmanship, and the rumbling euro crisis, will make for volatile markets through year end. As we write, too, geopolitical tension is rising again in the Middle East. But we continue to advise long-term investors who are disproportionately invested in ‘safe haven’ assets to view setbacks in developed equities, in particular, as an opportunity to build positions.

Kevin Gardiner, Head of Investment Strategy EMEA

Filed under: debt ceiling, Economics, EU, GDP, Trade deficit, US, US GDP | 1 Comment »

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