INVESTMENT REPORT MAY 2011

Back To the Beginning

 

Sovereign Debt

Iceland and Greece are back in the headlines. Iceland is refusing to repay the UK and the Netherlands the bail out money that it received at the beginning of the crisis and Greek debt is becoming increasingly difficult for them to finance as two year interest rates rise to almost 30%.

 

The European Central Bank's expansionary monetary policy, which has to take into account the weakness of southern euro zone economies, has boosted German growth. Germany has also seen steep falls in unemployment - to the lowest level in two decades - which fed through into stronger domestic demand in the first quarter. The economy grew by 5.2% in the last twelve months. The country's statistical office said consumer spending had risen 'markedly'. Unlike their British counterparts, Germans had not been on a credit-fuelled spending spree before Lehman collapsed: there has been no equivalent of the UK's credit crunch. Germany's strength could increase the pressure on it to provide more help to crisis-hit euro zone 'periphery' countries, such as Greece, Ireland and Portugal. It already appears to be indirectly helping neighbouring Netherlands, Austria and Belgium, which each saw GDP rise about 1% in the first quarter. Germany is therefore benefiting from the weak Euro caused by the Euro zone problems and its own lack of domestic debt. The main risk for Germany is the exposure of its banks to other Euro zone debt and the country’s political commitment to bail out these other countries. Germany is unlikely to be the breaking point for the Euro zone debt problems.

The cost of a Greek default to the German taxpayer alone would be at least 40bn Euros. A premature Greek default would change everything. As would the failure by the EU and Portugal to agree a rescue package in time; or an escalation in the EU's dispute with Ireland over corporate taxes; or a ratification of the European Stability Mechanism in the German, Finnish or Dutch parliaments; or a German veto for a top-up loan for Greece in 2012; or the refusal of the Greek parliament to accept the new austerity measures; or a realisation that the Spanish Cajas (regional banks) are in much worse shape than recognised, and that Spain cannot raise sufficient capital. There are about 5200 regional and local Spanish entities with indebtedness that is not included in the official accounts, amounting to some 26.4 bn Euros. Then there is the possible downgrade threat for French sovereign bonds. A downgrade would destroy the logic of the European Financial Stability Facility (EFSF). It is built on guarantees by the Triple A countries. Without France, the lending ceiling of the EFSF would melt down further.

One option would be to allow the EFSF to engage in secondary market bond purchases with the explicit remit of aiding a debt restructuring. The EFSF could swap its own triple A rated securities for Greek Bonds, at a discount. The counterparty (original bond holder) would suffer a loss on the transaction, but would gain a triple A rated paper in return. That would actually provide a market based incentive for holders of peripheral debt securities to swap. The euro zone has essentially three options: follow the ECB, and roll over existing debt for as long as it takes; change the rules of the EFSF and accept secondary market bond purchases; or force a full debt restructuring, and accept the consequences.

 

Some of the original bondholders are being paid with official loans that also finance the remaining primary deficits. When it turns out that countries cannot meet the austerity and structural conditions imposed on them and therefore cannot return to the voluntary market, these loans will eventually be rolled over and enhanced by euro zone members and international organisations. Does anyone imagine the IMF will stop disbursing loans if performance criteria are not met? This public sector Ponzi scheme is more flexible than a private one. In a private scheme, the pyramid collapses when you cannot find enough new investors willing to hand over their money so that old investors can be paid. But in a public scheme such as this, the Ponzi scheme could in theory go on forever, As long as it is financed with public money, the peripheral countries debt could continue to grow without hypothetical limit. But could it really? The constraint is not financial, but political. We are starting to observe public opposition to financing this Ponzi scheme in its current form, but it could still have quite a way to go. It is apparent that, if not forced sooner by politics, the inevitable default will only be allowed to take place when the vast part of the European distressed debt is transferred from the private to the public sector. As in a pyramid scheme, it will be the last holder of the asset that takes the full loss. In this case, it will be the taxpayer that foots the bill, rather than the original bondholders that made the wrong investment decisions.

 

My conclusion for the Euro Zone is that the countries with excessive indebtedness will be the breaking point, as bond holders demand ever higher interest rates for the risk that they are taking in lending to these countries. This will force the IMF and the ECB to exchange that debt for stronger debt thus causing a financial loss to the current owners of the Bonds. Alternatively, this current short term debt could be restructured to long term debt (30 years) thus allowing the heavily indebted countries more time to repay. Either way, fixed interest government bond holders will lose money and whilst the matter remains unresolved the Euro should continue to weaken.

 

$8400bn of debt has been downgraded in the first quarter of 2011. The UK continues to be the country most vulnerable to a continuation of the debt crisis with almost 500% of GDP in exposure compared to just over 300% in most of Europe. Countries whose financial institutions gross debt is at extreme levels compared with the size of its economy are Japan, France, Belgium and the UK. Taking account of the government sponsored housing agencies, the US general government debt is 130% of GDP (this excludes corporate and personal debt).

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Emerging Markets

In a new paper examining the economic record of emerging markets since 1957, the authors focus on countries whose GDP per head on a purchasing power parity basis grew by more than 3.5% a year for seven years and then suffer a sharp slowdown in which growth dips by 2% or more. They ignore slowdowns that occur when GDP per head is still below $10000 on a purchasing power parity basis, limiting the sample to countries enjoying sustained catch up growth. What emerges is an estimate of a critical threshold; on average, growth slowdowns occur when GDP per head reaches around $16740 at PPP. The average growth rate then drops from 5.6% a year to 2.1%.

This estimate passes the smell test of history. In the 1970's growth rates in Western Europe and Japan cooled off at approximately the $16740 threshold. Singapore's early 1980's slowdown matches the model, as does the experience of South Korea and Taiwan in the late 1990's. As these examples indicate, a deceleration need not precipitate disaster. Growth often continues and may accelerate again; the authors identify a number of cases in which a slowdown proceeds in steps. Japan's initial boom lost steam in the early 1970's, but its economy continued to grow faster than other rich nations until its 1990's blow up. China's growth puts it on course to hit the $16740 GDP per head threshold by 2015, well ahead of the likes of Brazil and India.

 

What this research fails to tell you is the impact that these slowdowns have upon stock markets. Japan’s stock market continued to rise until 1990, Singapore’s continued to rise in the 1990’s and South Korean and Taiwanese stock markets have continued to rise to date. The direction of stock markets are not always driven by rates of economic growth, they are driven by value and risk.

 

The annual rate of private sector credit growth in Brazil, Russia, India, Indonesia, Hong Kong, Thailand and China is above 20%. These are the highest monetary growth rates among the major economies. Very loose credit conditions have boosted excess demand, which has led to significant rising rates of inflation. A number of housing bubbles are inflating. According to Deutsche Bank, real estate prices are elevated in a number of Asia-Pacific countries. In Latin America, foreign exchange reserves are also exploding and credit growth is strong. Emerging market central banks have been tightening monetary policy to curtail credit growth and slow aggregate demand.

Unilever has agreed to pay a fine of $300000 after China's National Development and Reform Commission accused the Anglo-Dutch company of creating panic by announcing its intention to increase detergent and soap prices. The Chinese have declared the battle against inflation this year’s top priority. After all it was concerns about spiralling prices that first stirred protests in the run up to the 1989 occupation of Tiananmen Square. The price of food which accounts for one third of disposable income of the average household is rising at about 11.5% annually. Nevertheless, the Chinese have announced a five-year plan of allowing wages to outpace growth. In the past year, wages for factory workers have risen by, 20, 30 and 40%. The measure of money in circulation plus deposits is up 52% in the past two years. With so much money sloshing around, no wonder prices are rising. China's fixed investment is also likely to become a problem. According to Nouriel Roubini 'No country can be productive enough to reinvest 50% of GDP in new capital stock without eventually facing immense overcapacity and a staggering non-performing loan problem. In the short term the Communist party has said that it is willing to see growth fall in return for greater stability. Since October it has raised interest rates on four occasions and tightened up rules for bank reserves eight times. In response, industrial growth has fallen and retail spending has slowed to its weakest level in six years.

 

Emerging markets therefore offer short term risks with greater medium term potential. As emerging markets are the engine of world economic growth, their short term slowdown is likely to result in a slowdown in the developed economies of the world.

 

Inflation

The following information demonstrates asset class sensitivity to inflation in the short term and for each 1% rise in inflation since 1973:-

 

US Treasuries more than -1%;

US Corporate Bonds -2%;

US Equities more than -3%

Commodities +10%

Gold +6%.

 

If you assume that the rate of inflation may fall by around 3 to 5% in the short term, before rising perhaps by as much as 15% per annum with the next round of quantitative easing, you will be able to extrapolate both the short term and medium term potential returns for each of these asset classes.

 

 

 

 

 

 

 

 

Gold

Whilst the gold price has risen to record highs in US dollar terms, it has not done so in other currency terms because other currencies have been strong compared to the US dollar. The BlackRock Gold & General Fund is now back at prices seen in May and June of last year and therefore partially justifies our decision to take profits. A little more patience should result in lower prices and buying opportunities. Historically the Silver price was one-sixteenth of the gold price (being roughly 18-19 times more abundant) and this may explain the outperformance of silver over the last twelve months.

Property

Londoners feel insulated from the rest of the country. Optimists point out that five out of the six fastest growing regions in the UK are London boroughs. But at about six times average earnings, house prices in the capital are still over valued by 1/3rd compared with historic levels. House prices have already fallen for each of the past six months - before the austerity measures have kicked in. Further sharp falls look inevitable.

Stock Markets

Further signs of severely overvalued stock markets are:-

• 10 year treasury spreads are now below zero. The last time this occurred was prior to March 2009 and are often associated with broader market distress;

• The floatation of Glencore the commodities supplier;

• The flotation of LinkedIn the business social networking company, valued at about 40 times its 2010 revenues and 200 times its adjusted earnings before interest, taxes, depreciation and amortisation, the measure on which many investors assess such stocks.

Taxation

Total taxation as a percentage of labour costs are approximately 50% in mainland Europe. In the peripheral Euro zone nations, the UK, US and Japan they range between 29.7% and 37.7%. Expect the tax rates in these countries to rise significantly, particularly for higher earners and the wealthy. Accordingly, whilst maximising tax efficiency for clients we are not advising clients to defer tax liabilities unless they are likely to fall into a lower band of tax or an offshore tax haven in the future.

 

 

The views reflected herein are those of Mitchell Neale Investment Services and should not be regarded as a recommendation to invest in any one product or service; before investing you should always consider personal investment advice.

 

Mitchell Neale Investment Services does not accept any liability whatsoever for any direct or consequential loss arising from any use of this report or its contents. Investors should be aware that the value and income from investments can rise and fall and that past performance should not be considered as a guide to the future.

 

Mitchell Neale Investment Services

May 2011