Where to turn next?

In my last Blog entry on 4th November, I warned that (aside from the Eurozone issues) weak prospects for economic growth would keep any Equities rally in check. In the last three weeks, the FTSE has fallen by 6%, the Dow Jones Industrials has dropped by 4% and the Nikkei has retraced 5.5%.

The main catalysts behind the poor month are the usual suspects. The Eurozone debt problem lurches from one flashpoint to another, with Spain now in the spotlight. In the US, the bi-partisan "super committee" convened to tackle the massive US deficit had failed to reach an agreement, which will now lead to automatic cutbacks in budget cuts, due to start in 2013. Indeed, US growth for Q3 2011 has been downgraded from 2.5% to 2%, with similar downwards revisions expected for Q4. Even China has seen its manufacturing fall to a 32 month low.

In short, it feels like August all over again. With most asset classes (with the notable exception of UK Gilts, German Bunds and US Treasuries plus a handful of others) moving lower, what should investors do in conditions such as these?

Firstly, investors should remain calm, and remember that all investment is a medium or long term process.

Markets will inevitably fluctuate over the course of an investment cycle, and staying the course with a chosen strategy is arguably one of the safest bets. However, an added element to consider is that "risk free" returns - i.e. cash - are so poor, running for the relatively safety of cash is not really an option either. Certainly in the UK, there are very few if any deposit accounts that will pay a return to keep up with Retail Price Inflation (currently 5%), therefore cash returns are (by and large) condemned to loose value in "real" terms.

In these conditions, I continue to favour quality Corporate Bonds, selected sovereigns (particularly UK Index Linked Gilts) and Gold. However, should Equities fall much further from here, say by 10% or more, then on a fundamental basis,  selected positions will begin to look attractive, particularly defensive industries such as food retail and utilities.

As ever, seek professional advice from a suitably qualified person before taking any investment decisions.

Buying time or a real solution?

The announcement of a comprehensive list of actions at the EU summit on 26^th October has been warmly greeted by the market, with a real sense of optimism that the announcement could find a solution to the European sovereign debt crisis that has dogged markets for the best part of eighteen months.

The mere fact that the EU leaders appear to have reached a consensus does provide some cheer, as for many months it did not appear that a common view was shared. However, as ever, the devil is in the detail. The first measure announced was the size of the European Financial Stability Fund (a special vehicle financed by EU members and designed to provide assistance to its members as necessary) is to be increased to €1tn. This should allow sufficient capital to reduce lending costs and provide liquidity, but would fall short in the event that both Italy and Spain were about to default.  Secondly, bondholders in Greek Government debt (mainly other European banks) are to take a 50% “haircut” (loss) on the value of their Bonds. This will ease the immediate pressure on Greece a little and potentially could reduce their debt levels to 120% of GDP by 2020. However, the country still has a long road ahead, with austerity measures likely to continue for many years, and will also involve the privatisation of some Greek institutions.  Any deviation could still ultimately lead to Greece defaulting on its’ debts.

Additional measures announced include a requirement for European banks to bolster their cash reserves by mid 2012, with initial estimates suggesting a total of €106bn will need to be raised. The European Banking Authority has recommended that Banks unable to meet the criteria withhold bonuses and do not declare dividends, before seeking fresh capital from Governments. Any further bank bailouts would, of course, prove unpopular, but may be necessary.

However, the deal is not done, as the Greek Government had announced that it intended to hold a referendum on the bailout package in January. Given the unpopularity of the austerity measures, it is quite possible that any vote would go against the package, sending the crisis back to square one. However, it now appears that the referendum has been shelved for the time being, as a compromise between the two main Greek political parties. 

Whilst providing a short term fix, the deal still does not tackle the fundamental issue that Eurozone growth is negligible at present, and unless the prospects for growth improve rapidly, other Eurozone nations (other than Greece) with large debt to GDP ratios, such as Italy, Spain and Portugal, will continue to face the same issues. In short, debt levels in these nations are increasing still, and until this reverses, the problem will not go away. Indeed, market attention is likely to refocus on the likes of Italy and Spain, which are much larger economies than Greece, and in that respect, a bigger problem.

The debt crisis has also provided something of a “smoke screen” to cover the other crucial factor, that the US, UK and Eurozone economies are perilously close to fall back into recession. Whilst initial market reaction has been positive, and I do expect Equities to be more positive than of late, weak economic data flowing through for the final quarter of 2011 should keep any substantial Equities rally in check.

The Quest for Income

Since March 2009, the Bank of England has anchored the minimum Lending (or “Base”) Rate at just 0.5%, which is unprecedented in two ways. Firstly, it is first time in 300 years that the Base Rate has been set at such an ultra-low level. Secondly, it is highly unusual for Base Rates to stay at the same level for such an extended period. Furthermore, the Base Rate is set to stay where it is for some time to come.

Aside from the historic perspective, the knock-on effect on cash deposit interest rates has dealt a vicious blow to anyone who relies on income from savings to supplement other income, such as Pensions. In a double whammy, Retail Price Inflation nudged past 5% last month, meaning that the real value of savings is being eroded. The average branch based instant access account now pays less than 1% per annum gross interest, and whilst this rate can be improved upon by using internet or phone accounts, you will be hard pressed to find any instant access account that pays more than 3% per annum. Indeed, due to the fact that Banks and Building Societies have had to pay more to borrow money over recent weeks (as a result of the Eurozone debt crisis) deposit interest rates have been steadily falling even further since the Summer.

But what can investors do to increase their income? Firstly, using Cash Individual Savings Accounts (or ISAs) will increase the income stream for basic and higher rate taxpayers, as then interest will be paid without deduction of income tax at source (non taxpayers will see no advantage as they should not pay any income tax on their savings in any event). But Cash ISA rates are little better than ordinary deposit rates, and the annual allowance limit, currently £5,340 in the 2011-12 Tax Year, is restrictive

Beyond the Cash ISA, for all but the most risk averse of investors, there remains value in Fixed Interest Securities as a way of achieving an improved income stream from a capital sum. Fixed Interest securities are debt issued by either Governments or Companies as a way of them raising finance through the markets. They come in many different guises, but the most common for domestic investors are Corporate Bonds (debt issued by Companies) and Gilts (debt issued by the UK Government).  Fixed Interest Securities (as the name suggests) tend to pay a fixed income for a fixed period, when the issue is redeemed at a pre-determined price (usually 100p), subject to the financial ability of the company to repay. In the unusual event that a Bond issuer cannot repay, this is known as a “default”, which could lead to a percentage loss on the capital value (colloquially known as a “haircut”). In the event of a default occurring, Bond holders rank ahead of ordinary shareholders in the queue to receive their capital.

There is a wide range of Corporate Bonds in circulation, issued by a vast array of different companies. Lending money to the most financially secure will tend to yield a lower income than lending to a less secure company. This is the trade-off between risk and reward, as investors in lower graded debt, with a higher chance of default, demand a higher rate of interest to compensate for the risk.

Despite the economic conditions, default rates remain at very low levels, particularly in the higher graded Bonds. According to research carried out by M&G, default rates on investment grade debt (i.e. BBB+ or better) stands at between 1% and 3%, and Higher yielding debt (i.e. BB) at 9.6%. Default rates can be minimised further by investing in a collective investment, which holds a range of Bond investments, so as to obtain an adequate spread and diversification across a range of issuers.

At the lower end of the risk scale, UK Gilts (issued by the UK Government) yield between 2% and 3% gross per annum. Slightly more risky than Gilts, Investment Grade Corporate Bonds (i.e. those rated BBB+ or better) yield between 4% and 5% gross per annum (and in my opinion represent the “sweet spot” at present between risk and reward). Higher Yield issues yield 6% gross per annum or better. These compare favourably to cash interest rates at present, but it is important to bear in mind the default risk; in addition, a further risk inherent with fixed interest investments is that they tend to become less attractive in periods when interest rates rise rapidly. However, in the current climate, this appears a remote possibility – our current estimate is for the Base Rate to stay on hold until the end of 2012 - but in the longer term, this factor should be borne in mind.

Corporate Bond prices did suffer a little during the late Summer market malaise, but have begun to rebound over the last few weeks. They remain an attractive investment proposition in the medium term, and certainly give an option to boost income in this unusual period when cash returns are so unattractive.

As ever, before committing to any investment strategy, you should seek impartial advice from a qualified investment professional, and any decision should take into account your personal circumstances and tolerance to risk.