Europe! What is happening?

We have seen much volatility in economic markets over most of 2011, partly caused by the historic problems of the Euro and the European zone. Some are predicting further recessionary pressures in various economic zones and Europe is one of them. I have provided comment on this in a previous blog in July 2011, when Greece first started to make front page news, having reached its first decade in the EU. This blog was entitled ‘There may be trouble ahead….Still!/Europe’ and this has certainly proved to be the case as we reach the end of 2011. With David Cameron declining to sign up to the detail of the proposed new treaty overnight (08/09 December 2011) where are we and Europe now….as far as we can surmise?

Although we have our own significant views on investment and asset allocation, to ensure that our recommendations, views and advice is robust, we also employ the services of Cormorant Capital Strategies Limited, to help with our processes.

I have asked them to comment and they have provided the following thoughts:

There are a number of issues I want to lay out. This is not another note on the euro-zone crisis however. To focus on that one issue would be to threaten to miss the wider trend. The wider trend I speak of is characterised by an unusually weak and protracted recovery, most evident in the UK but also apparent in our G7 friends^[1]. The euro crisis is one of three noticeable threats to the global economy^[2] and while I don’t wish to underplay its significance, ultimately I feel the greater danger to investor’s wealth is that posed by sustained low growth allied with poor credit availability.

Before I begin in earnest I really want to tell you that I think much of the gloom that I have read of late is overdone. Actually, a lot of what I have read and a lot of what I have heard from politicians and investment managers have angered me. Let’s begin by framing the discussion to come.

It is my assertion that, if there are ‘investors’ who are unable or unwilling to burden losses over what might be a period of years without selling their positions in the interim then they ought not to be invested in the capital markets (the equity and bond markets). That is not a comment I attach to a particular forecast, trading strategy or timeframe. It is a rule and it applies always, even when the prospective economic environment is benign.

The capital markets exist for one purpose – that is to bring willing lenders (or investors) and willing borrowers (or entrepreneurs) together. That process necessarily involves some risk. I say ‘necessarily’ quite deliberately. Risk is not an unpleasant side effect; it is a pre-requisite for proper functioning capital markets and try as you might there is no getting away from it. The reason any asset pays a return is that it carries risk. If anyone tells you otherwise they are either lying or they are ill-informed. The risk is of capital loss in varying degrees.

The capital markets, and by extension capitalism, work well when all participants are reasonably well informed of the risks they are taking. It is probably the most productive system of all those we have tried in the last few hundred years for allocating capital efficiently. The most recent past has seen terrible meddling in the capital markets (for ‘deregulation’ read ‘rigging’) by politicians, central banks and regulators, but that is a subject for another day. Suffice to say that what has made me most angry in the relatively short time I have worked in the field of investment management (15 + years) is the development and rapid expansion of what I can only describe as an unpleasant sub-system of the financial markets. Many investors – institutional and retail – have been enticed by the promise of high returns and low risks. It is one which Michael Lewis, contributing editor at Vanity Fair, describes eloquently as ‘a tool for maximising the number of encounters between the strong and the weak, so that one might exploit the other’.

So, those who are unwilling or unable to burden the risk of capital loss over what could be a significant period of time can stop reading – they have more pressing matters and a lot of unwinding to do. It’s that simple, there’s nothing people like me can do to prevent the risk of loss. Willing investors read on, perhaps we can mitigate a little of that risk.

I will, of course write a little about developments in the euro-zone. But, first, I want to deal with a background trend that has been developing before and will continue to affect asset prices after the euro-zone crisis has fallen from the headlines (though a continued string of EU summits will doubtless conspire to keep it on page one for many months to come). The pace of recovery from the 2008 recession is an incredibly disappointing one, one which brings with it deep risks. In my discussion of this I will draw heavily on a speech made by Martin Weale, an external member of the Bank of England’s Monetary Policy Committee, which he delivered at the National Institute of Economic and Social Research in London on 25 November. It’s a great piece of work and is available to anyone to download from the speeches page at www.bankofengland.co.uk.

‘Even before the recent problems with the euro area, most countries were experiencing a disappointing recovery from the aftermath of the recession which began in 2008. In the United Kingdom things have been particularly slow’.

To provide some background to this assertion Martin points out that, of the five UK recessions since 1920 and before 2008 the recovery period has probably not lasted longer than 49 months. That is to say that Gross Domestic product (GDP) tracked back to the level of the previous peak in a little over four years. In the international context, the International Monetary Fund estimates that the average time taken for a country to recovery from a recession is just over 27 months. That rises to around 52 months if the recession is closely associated with a banking crisis. If we take the Bank of England’s central estimate for GDP as a reasonable guess at when we might see output in the UK regain the level it showed prior to the 2008 recession (the sixth since 1920) the current recovery period will have lasted for somewhere between 66 and 72 months – five and half to six years. GDP in the UK has not, thus far, fallen as far as it did in the 1930s (7% compared with 9% then) so the current recession has not proved as deep, but certainly in terms of duration it is likely to be the worst. Personally, I think there is a good chance that we will at least flirt with another recession in 2012 which might push back the 2013 target.

Other G7 countries, most notably Canada, are well ahead of the UK on the recovery path. Only Japan (owing to the Tohoku disaster) and Italy (even before the current heightened weakness) lag the UK. For some reason, the UK has been hit especially hard. Martin and his colleagues at Cambridge University find this hard to explain. Needless to say I am unable to shed any light on the matter^[3].

Martin’s work goes on to examine the role of both productivity and consumption in his speech. I think he probably places greater weight on the role of productivity in affecting the recovery process but I want to share with you his observations about the path consumption has taken since the beginning of the 2008 financial crisis.

‘Consumption fell by more than 5% between 2008 and 2009, its largest peace-time fall since that of over 8% in 1921; unlike the early 1920s it has shown no real recovery’. Why might this be? Consumer confidence remains weak, of course, but household incomes, in the aggregate, are at least no lower than those prior to the recession.

Martin discusses a number of competing explanations that do a good job in explaining why this might be. Naturally I am going to add weight to the one I have most sympathy for… ‘…particularly at a time when incomes are weak, they [UK households] might not have access to the resources they need to maintain their spending’. It has been my contention for some time that very low real wage rises, particularly in the last decade and a half, have been supplemented by a credit grab to maintain high rates of consumption. Now that credit has been withdrawn the previous path of spending has collapsed. ‘Obviously the chance of this happening is particularly high if credit has tightened unexpectedly; it may be affecting some consumers even though, as we have noted, income in the aggregate has held up better than consumption’. Added to the mix is the expectation that both job prospects and credit availability will continue to be muted well into the future, so consumers are saving[4] to ‘build up a buffer against future shocks’ and, perhaps for some, the increased deposit required to purchase a home. This rational course of action is probably having a greater impact today because of the very low rates of saving prior to 2008 when we all thought things were only going to get better; our houses can only go up in value, our job prospects improve and banks’ credit card subsidiaries increasingly generous.

I think the problem of weak consumption is going to go on for some time. There’s a cycle here and it has worrying aspects. Weak job prospects, slow wage growth and poor credit availability are also affecting house prices. That doesn’t just have a detrimental effect on consumers; the future of many successful businesses has at one time or other been secured on an entrepreneur’s home. It’s not all bad news though. Our economy doesn’t have to rely so heavily on consumption. Indeed, the balance of aggregate demand needs to shift away from household and public consumption towards net trade and investment if we are going to see sustainable rises in prosperity over the longer term. As it stands, the Bank of England does not have a policy tool to promote such a re-balancing. But we can see strands of this thinking in their other policy actions and I hope we will see it in the policies of government too.

The Bank, for its part, is trying to support ‘aggregate demand’, not just the consumer. The Monetary Policy Committee took a collective risk in looking through a period of high inflation[5] and maintaining its loose monetary policy stance[6]. Arguably this period of high inflation, allied with low wage growth and culminating in a decline in real wages, was a painful but necessary step in the rebalancing process (making UK exports less expensive for overseas purchasers). Ultimately of course, the Bank is judged on its ability to meet the 2% inflation target in the medium term. The medium term is up now, I think. If inflation does not fall, as the bank believes it will, sharply in the opening months of 2012 then it will have lost a good deal of credibility. Personally, I think that had the bank responded to higher inflation with tighter monetary policy in the interim we would have seen a stalled recovery and conditions would have been far worse than they have been. I also think that the Bank is right and that inflation will fall sharply early next year[7]. That would go a long way to improving our lot.

If we do see a rapid decline in the rate of inflation in the early months of 2012 it should to be seen as a vindication of the Bank’s policy actions over a period of time in which it has attracted much criticism. For that matter I also think that a fall in inflation will be a pre-curser for an expanded quantitative easing package – even beyond the £275 billion which will have been laid out by the end of January 2012. The Bank is keen to hold gilt yields low, given that these are the rates of interest most likely to affect the cost of borrowing for businesses and given that credit availability to business is a terrific risk to the downside for inflation. This observation infers that now is not the time to encourage lower allocation to conventional gilts in investor’s portfolios. I make this last point because I have seen a great deal of ill-informed speculation about the relative attractiveness of gilts at this time. More on the subject of things you can actually invest in, as opposed to the slightly nebulous commentary on the macro economy, later. For now though, a little on the euro zone.

The euro-zone is on the brink of disaster, we know that because that’s what everyone says, including the chap that came to fix my TV aerial. What most commentators are not acknowledging is that there is nothing the European Central Bank (ECB) can do about it. Calls for the ECB to do more than it is doing already are naïve. Even if the ECB had a mandate which would allow it to print the trillions of euros necessary to remedy the region’s debt problems, the likely impact would be to create inflationary problems^[8] in their stead. That is why the German government is rightly opposed to such a move. What the ECB can do, of course, is help to provide liquidity in an effort to prevent another credit crunch. This is precisely what the ECB is doing, to great effect thus far. In acting in concert with the other major central banks it is working hard behind the scenes to buy time. But this is not a crisis of liquidity so much as a crisis of solvency.

Unfortunately, the 3-point plan^[9] is probably not enough. On the day that the deal was announced[10] European stock markets sighed with relief and produced terrific gains. The bond markets saw little in the way of celebration though. Spanish and Italian government bond yields (in the ten-year range) have breached 7%, though limited intervention from the ECB has brought yields a little lower. Contagion is a formidable problem. In isolation, a Greek default, orderly or otherwise, or exit from the euro does not have the potential to fatally damage the monetary union. In contrast Spain and Italy alone have funding requirements of around €800 billion in the next few years. That makes the €1 trillion European Financial Stability Fund (EFSF) look less like the firewall it was intended to be. Some would argue that the EFSF needs to be closer to €3 trillion. The fund is a long way off that amount. Worse still, if France gets embroiled and loses its AAA credit rating the loss of faith on the guarantees she has made to the EFSF will be fatal to the fund.

Only Germany has the power to progress the situation. In the meantime the euro-zone will remain on the brink of disaster until we see much closer fiscal union (requiring a treaty and amendments to the ECB’s responsibilities) or investors in Greek bonds (and other distressed euro-zone sovereign debt) take a significant and unambiguous loss. Perhaps we will see both. A full collapse and a breakup of the euro zone is, in my opinion, a far more remote possibility than it is currently believed to be, even if a Greek default is inevitable and a number of European banks are nationalised. Expect another much-hyped euro summit to be scheduled soon after the next much-hyped euro summit.

Whatever happens in Europe and whatever happens in the US, however long it takes the UK to recover there is one thing I am certain of and that is that the economies of the UK and our G7 friends will recover. The bond markets and the equity markets will signal that in time. Before then though none of us should be surprised if we see further recession. A slow and protracted recovery comes hand in hand with a greater potential for setbacks. We have not yet achieved escape velocity. Which brings me to my final point.

Equities and bonds ought to make up the bulk of an investor’s long-term portfolio^[11]. Today though, the gross redemption yield on the 10-year gilt is 2.3%, on a basket of sterling investment grade corporate bonds you might get a little over 5.0% for ten years and the annual dividend yield from the FTSE 100 is 3.6%. I calculate a prospective 10-year total return of around 7.4% per annum for the FTSE 100. On this last measure, the FTSE 100 is relatively attractively priced among the more mature markets. Other equity market aggregates, like the S&P 500 in the US, the DAX 30 in Germany or the TOPIX in Japan, do not hold the promise of returns which are sufficiently high to justify the risks they carry. It’s not a terribly enticing menu, so to speak. Almost across the board, I see risky assets which are priced higher than a level with which I would be comfortable. When asset prices are high one of three things will happen. They will go higher, go lower or stay the same. I don’t know which of those scenarios is going to play out. So, quantify your risks and ensure you’re comfortable with them.

Steve Williams

Managing Director

Cormorant Capital Strategies Limited

1 With the exception of Canada; on some measures she has now surpassed her pre-recession level of output.

2 Watch out for further wrangling over US debt levels and rising tension over the Iranian nuclear programme. A US default or a nuclear armed Iran are potentials as unappealing as a euro-zone meltdown.

3 Martin will not be drawing heavily on any of my works in his future works.

4 It is probably more accurate to say that they are ‘not borrowing’. If one pays off a credit card, it increases one’s net worth which is akin, in economic parlance, to saving.

5 The annual rise in the Consumer Price Index has been well above the Bank’s target range since late 2009.

6 Bank Rate, for example, has been 0.5% since March 2009

7 Though not soon enough to save my bet that inflation would be back in range by the end of 2011. You win some, you lose some.

8 It is possible for ‘quantitative easing’ to be rolled out without creating such problems – as looks to be the case in the US and UK and has certainly been the case in Japan – but it seems likely that the mix of circumstances in the euro-zone would result in too high an inflationary price.

9 (1) Greek debt restructuring of 50% rather than the previously agreed 21% (2) bank recapitalization measures and (3) expansion of the European Financial Stability Fund to somewhere between €1.2 and €1.5 trillion. Even if the plan is implemented successfully, the Greek economy faces further contraction (Moody’s Economy.com suggests another 10% on top of the 16% shrinkage already seen) with serious consequences for its citizens for many years to come. A write-down of 50% of the value of Greek bonds is intended to bring the Hellenic Republic’s debt-to-GDP ratio down to 120% by 2020. That is a level that, EU officials suppose, is fiscally sustainable but this assumption is suspect, not least because it is far from clear that 50% of Greek debt will actually be written-off.

10 27/28 October if my memory serves me well.

11 There is, of course, a powerful argument for less traditional forms of investment and I am an advocate of some. Just ‘some’ though.

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We do not necessarily agree with all the view noted in the comments above. However, it does provide a flavour of where we are up to into the Eurozone process.

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Keith Churchouse FPFS
Director of Churchouse Financial Planning Limited, Guildford, Surrey

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