A very simple and poignant analysis from the FT yesterday:
Imagine a country that spends and prints trillions to patch up any problem.
Now imagine another country where there is no central Treasury, meaning that bail-outs are less easy, and which has a central bank that’s mopped up liquidity over the past year, rather than engage in quantitative easing.
Why does it surprise anyone that the latter, the eurozone, has a stronger currency than the former, the US?
Regards
David
The human toll of the recent Japan earthquake may be disastrously high but the economic damage is likely to be “limited” according to most commentators.
Although, economic growth in Japan will undoubtedly take a hit (and current forecasts point to a 2% reduction in GDP) following last week’s earthquake and tsunami, the longer-term impact on the country’s fragile economic recovery should be muted and the impact on global economic growth limited.
There are still a lot of unknowns at the moment but, inevitably there will be micro-economic disruptions, as there were after the Kobe in 1995. However, many firms reportedly diversified supply chains in the wake of Kobe, so the impact should be lower this time around.
Shogo Maeda, head of Japanese equities at Schroders, adds: “We do not believe there has been serious overall damage to the business sustainability of many Japanese companies. As more information becomes available from the companies with regard to the damage caused, we think the market will become more stable.”
Most investment managers are taking a similar view where the best strategy might be to allow the dust to settle before taking any action.
In summary:
- The chaos caused by the earthquake so far appears to have had relatively little impact on global markets compared to what has happened to domestic Japanese markets; the Topix index posted its worst two-day fall since 1987. Economic & Fiscal Policy Minister Kaoru Yosano stated that markets will eventually stabilise, and there was no reason to suspend markets.
- The Yen has strengthened against 15 of its 16 most actively traded currencies on speculation domestic investors will repatriate assets. Standard and Poor’s stated today that the earthquake had no immediate effect on the nation’s AA- sovereign credit rating.
- Japanese authorities have been quick to respond and the Bank of Japan announced that it will add 5 trillion Yen to its asset purchase programme and is providing 15 trillion yen ($183bn) of liquidity to financial markets. The BoJ’s further loosening of monetary policy today may also have helped ease some concerns about the impact on Japan’s economy itself.
- There is an optimistic perception that natural disasters can eventually be turned into a positive for the economy because of the boost to demand from reconstruction work, however markets might be too complacent about the implications of what is happening in Japan. Private domestic demand was already fragile before the disaster struck and the public finances are in a dire state. Given Japan’s importance as a global investor this could have significant repercussions globally.
- Demand for safe havens such as US Treasuries / UK Gilts, the dollar and gold is likely to remain high.
Talk of Quantative Easing (and more recently, QEII – the quaintly titled second round of possible Quantative Easing) has been in the press for the last year or so but, in answer to the question of “what next?”, there appears to be two distinct camps.
Austerity?
In Europe (and certainly the UK), austerity is de rigueur as nations seek a fine balance between balancing the books and keeping economic growth alive. Easier said than done. The only plausible reason I have seen for “QEII” in the UK come from Fathom Consulting who has urged the Treasury and the Bank of England to join forces and create a new “bad bank” to buy lenders’ worst mortgages in an effort to unblock credit supply.
In short, during the good times, banks lent too much money against assets that have subsequently fallen in value. It is those losses that have to be fully recognised and, until they are, it will be difficult for the economy to move forward. Banks are not writing down the potential bad debt as low interest rates allow them to defer the issue. However, lenders are aware they remain vulnerable and so the credit supply remains restricted. Banks currently have a capital shortfall of about £20bn if assets were marked to market but the shortfall would rise to £180bn if house prices were to fall by 20% by 2012 – triggering another credit crunch.
In the meantime, many British households are being kept afloat by low interest rates which cannot last forever. Research from the Council of Mortgage Lenders found that 2.9m homeowners would have home loans that breached the FSAs affordability guidelines if rates rise by just 2 percentage points above the current of 0.5% rate. If rates were to rise to 3.5% then the debt servicing burden would match its peak at the height of the crisis. Fathom has also pointed to evidence that households are no longer paying off their debts, a sign that low interest rates are being taken as the norm – potentially trapping policymakers with near-zero rates.
To avoid this, Fathom has suggested that QEII might be used to create a “bad bank” to buy non-performing mortgages from lenders. In turn this would free up the banks to resume normal lending and provide the foundations for a sustained economic recovery.
The printing press?
The alternative in the US is to pump more money into the economy in a less structured manner and, in addition to the existing QE of $1.7tn, a further injection (QEII) of $600bn was announced earlier this week. This is seen by many as a huge gamble.
A fresh infusion of capital into the economy may or may not provide a lift for flagging domestic demand but one thing is certain, the move provides further downward pressure on the US dollar.
By pumping more dollars into the world economy, America risks undermining the faith in the dollar as a global store of value and is thereby squandering an asset of huge importance to the nation’s history.
The dollar’s reserve currency status means that America can borrow at will in its own currency from the rest of the world. This privilege is being thrown away. Every time the Fed prints more dollars to fight the domestic recession, it further devalues that debt. Lenders in turn are understandably getting anxious and the dollar’s all powerful reign on the world stage is drawing to a close.
There is no apparent plan in the US to reduce debt in a way that will not damage growth, while zero interest rates calls into question the dollar’s international standing and therefore the nation’s ability to refinance itself.
If you would like to discuss how these moves in the global economy may impact your investment portfolio needs, please do get in touch at info@thefrygroupsg.com.
Thursday could be an interesting day for European banks. Not only are markets braced for governments to cut back but central banks are also talking about cutting back, removing some of the stimulus pumped into the global economy over the past year or so. For example, this Thursday, the European Central Bank (ECB) reviews the terms on around half a trillion euros of the banking sector’s overdraft.
So what might happen?
Just under a year ago, the ECB loaned out €442bn at an interest rate of 1%, designed to help banks get through the credit crunch. Banks were allowed to borrow the money by pledging other assets as collateral. But now that money is due to be repaid on Thursday.
The ECB is offering the opportunity for banks to roll-over the debt but, as you might suspect, the terms are less favourable. The ECB will allow banks to borrow for three months at a time, rather than a year. The interest rate remains at 1%, but because it’s shorter-term, it increases pressure on banks to find longer-term financing elsewhere.
So what’s likely to happen?
Most banks would rather revert to a normal market situation and get replacement funding in the market, rather than from the ECB – it’s cheaper. But if more banks are chasing funds, then that will drive up the cost of borrowing through the laws of supply and demand. So one side-effect of removing the ECB liquidity will be to push up the cost of money. That feeds through to everyone else, including us consumers at the end of the line.
However, this is based on the assumption that banks are able to get decent access to all the funding they need from the markets. The other outcome is that banks will return cap in hand to the ECB with demand for this short-term funding. If the collateral that banks have been using is poor quality, then there might not be anyone in the open market willing to lend to the banks. So, if lots of banks take advantage of the ECB’s three-month loans, it’s a bad sign.
That could make markets more paranoid about the state of the banking sector and, in turn, push up borrowing costs as investors become even less keen to lend money to European banks. At the end of the day, this remains a solvency problem, not a liquidity problem.
Liquidity problems tend to go away by themselves. They’re caused by short term panic which causes otherwise healthy businesses to falter because they can’t get hold of the cash they need to conduct their day-to-day business.
The idea is that if the central bank acts as a “lender of last resort” and provides the liquidity, the market will get over its panic and life will continue as normal because there’s nothing fundamentally wrong with these businesses. So there’s no need to change your business model or acknowledge that there’s anything wrong.
The trouble is, there is something wrong with the European banking system. The fact is that there are a lot of bad debts out there and no one is entirely sure where they are. So, this isn’t about liquidity, it’s about solvency. For as long as that uncertainty is left in the market, it will be very difficult for the ECB to let the system stand on its own two feet.
In the meantime, global stock markets have fallen sharply amid these concerns over European banks and the health of the global economy. Yesterday, the Dow Jones Industrial Average closed down 2.65%, adding to similar falls in Europe and East Asia.
The euro has also weakened in the face of this uncertainty, helping push the pound to a new two year high against the euro (up to 1.2389 euros). All the while that there is tension in the banking sector, the euro will remain under significant pressure. Little is likely to change until the results of European bank stress tests, which should reveal the extent of bad loans on their books, are released in September.
The UK government’s austerity plans have also helped GBP gain value – fears in the market about the UK’s large budget deficit have been allayed by last week’s Budget in which the new government announced stringent measures to cut spending and increase taxes to reduce debt levels. Sterling has also benefited from comments made by Bank of England Monetary Policy Committee (MPC) member Andrew Sentance on Monday, in which he said the UK would need to start raising interest rates “soon”. Higher interest rates make sterling a more attractive investment and tend, therefore, to increase its value.
Wider concern about the strength of the world’s biggest economies has also hit investor confidence. For example, there is evidence to suggest a weaker recovery in China and the US. Influential US forecasters the Conference Board said the Chinese economy probably grew by 0.3% in April – much lower than the 1.7% growth previously estimated. Meanwhile the same body’s index for US consumer confidence showed a sharp drop for June, following three consecutive monthly rises.
So, what to do?
As ever, maintaining a diversified approach to asset allocation is going to help protect investors from any further short term volatility. Cash on deposit remains at close to zero returns and so, by maintaining a sensible spread of good quality assets and keeping focussed on ones long term aims, investors should not become too unstuck. By way of example (and, for legal reasons, I am not permitted to name these funds) I have summarised below the 5 year track record of two popular funds that we currently use (measured against cash returns), both of which follow a very proactive approach to asset allocation in the pursuit of real returns and the protection of capital.
I was recently asked about my thoughts regarding the “North Atlantic Peso” (Sterling to you and me!) and its outlook. Whilst I am no currency trader, I thought I would share my reply below. This is particularly relevant for anyone investing for a GBP return over the coming years.
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By all reasonable measures (see here: Currency values. Source: Investec Asset Management), GBP is seriously undervalued although, as ever, many of these measures are based on past statistics and who is to say that we are not now in a new paradigm where GBP is going to be permanently weaker?
If it were me? My gut says that GBP is too low and, once some sense of normality returns to the global economy, it will appreciate in value. At the very least, I would be inclined to sit tight for the time being. If you wanted to be more aggressive, you might want to look at funds which are 100% hedged into GBP. Against a back drop of ultra low interest rates, the outlook for global equity markets remains positive and, by hedging back into GBP, you eliminate any exchange rate risk and benefit if GBP strengthens.
Example, unhedged:
If you invested GBP100,000 into a global equity fund now, maybe only 10% – 20% of the underlying assets would actually be denominated in GBP. The balance would be in USD, EUR, etc.
If, over the next 12 months, markets appreciate by 10% but GBP also appreciates by say 20% against all other currencies, your GBP100,000 investment will actually have fallen to GBP95,334.
Example, hedged:
Using the same example but assuming that we use a fund which hedges all the currency exposure back into GBP, we have the same starting point but a very different picture at the end. Assuming market growth of 10% and applying that to a 100% hedged GBP portfolio, the fund will have grown to GBP110,000.
I hasten to add that there are plenty of ifs, buts and assumptions included here but if you are of the view that GBP ought to appreciate in value over the coming months/years then hedging some of the portfolio into GBP will give the portfolio some measure of protection. See what you think.
After a decade or more of relatively stable exchange rates, the recent volatility seen in the FX market has taken many by surprise and upset many expatriates’ plans. Some of you will have seen articles in the press recently about retirees in Spain who have endured a 30% cut in income due their sterling based income being eroded through a deteriorating GBP/EUR exchange rate.
So, more than ever before, give consideration to currency issues. By the same token, don’t let the currency “tail” wag the investment “dog” but give consideration to currency when conducting your financial planning. For instance, you may have come from the UK and are currently living and spending in Singapore so will think in terms of GBP and/or SGD. However, if it is your intention to one day retire to Europe, you ought to think about building up assets in EUR. Although the Euro is deemed to be expensive at the moment, who is to say what will happen in the future and so good advice is to gradually accumulate your future home currency through regular savings or regular transfers of capital. Unless you feel particularly strong about it, don’t try and time the exchange. Currency management is a “mug’s game” according to one fund manager I spoke to recently so, instead, set some rules by which you will transfer money and stick to them.
When converting money into another currency, also be wary of the “currency red herring”.
What I mean by “red herring” is that, for example, a fund denominated in Euros may be referred to as a “Euro investment”, but if the fund investment policy is to invest in European equities, then the investor may be exposed not to just the Euro, but also to other European currencies, such as Sterling, Swiss Franc and the Scandinavian currencies that remain outside the Euro. Assuming the fund’s assets are spread amongst European stockmarkets, weighted according to their relative capitalisation, it will carry around a 30% of its exposure to non-Euro denominated assets.
It is ever so important that this issue is clear and that you are not misled into believing that a fund denominated in, say, Euros gives added security over an alternative currency denomination. If the underlying assets are the same then it makes no difference what the fund denomination is.
A simple example shows why currency denomination is irrelevant.
Assume an investor wanted to invest US$100,000 into a US dollar denominated UK Equity Growth Fund. Overnight, markets don’t move but the USD/GBP exchange rate plummets from 1.6 to 3.0. Is the investor worried?
Actually, he has been protected from this currency drop because of the assets that he holds within the fund. On making his initial dollar investment, this cash would have been converted in to Sterling denominated assets (remember, this is a UK Equity Growth Fund) and so, at the original exchange rate, he is now holding £62,500 of assets within the fund. The morning after, if markets have not moved, his holding still stands at the same £62,500. If he elects to sell now though, the assets will need to be converted to cash and, at the new exchange rate of 3.0 US dollars to the Pound, he will receive $187,500.
To look at this a different way, if we expect the Euro to increase in strength then there are three potentially correct choices to take advantage of this:
As shown above, the incorrect choice is a different fund (say a UK Equity Fund) that simply happens to be denominated in Euros.
A good client of mine recently said to me: “I’m worried what currencies are going to do next so I’m putting my savings into Swiss Francs at the moment. I’m only interested in Swiss Franc funds.”
When we talked this through, I realised that he didn’t particularly want to put his money into a Swiss Franc Currency Fund – this would be pure currency speculation and not what he wanted as his main investment.
Neither did he want to put his money into Swiss Bond Funds. These would be less currency speculative, but would mean taking a view on Swiss public finances, inflation etc.
Swiss Equity Funds were mildly more interesting to him, although he didn’t really have a view on local corporate profitability and, with the Swiss stockmarket only accounting for 2% of world equity markets, he felt it was too narrow as a single country fund.
So, what he really wanted was a broad, managed fund but with the “comfort” of Swiss Franc denomination. However, even here, this “comfort” cannot be provided by simple Swiss Franc denomination.
Convincing my client was not difficult, but he was quite taken aback at how wide of the mark his original ideas were.
Once you peel the currency issue away you are left with the genuine issue – that of the nature of the underlying assets. Make sure you aren’t the one to be caught out by this ‘red herring’.