Euro Crisis - Part Deux ?

Politics and markets have always been intrinsically linked, but seemingly never more so than at present. The events in France and Greece over the weekend have cast into doubt the Eurozone restructure package brokered by Germany, and send Equities markets lower as investors once again ran for safety.

Francois Hollande's momentous victory, and the words "austerity is not the only option", will certainly ruffle Germanic feathers, though I would suspect Hollande would not want to derail the marked improvement seen in the borrowing terms of a number of Eurozone countries during the early part of 2012. Hollande is quite correct when he says that austerity isn't the only option. However, the other option, which may well feed into higher inflation and a greater crisis, is not a palatable one. We will need to wait and see how much of Hollande's rhetoric converts into actions.

The Greek election results may pose more of a problem to the Eurozone than the French verdict. The fact that a large swing in the Greek polls to anti-austerity measures shows the depth of feeling and despite Merkel's initial assertions that the Greeks must stick to the terms of the bailout package, I feel this is now in doubt.

What does this mean for investors? I suspect an increase in volatility, and possibly a retreat in Equities with monies flowing into the usual safe havens of UK Gilts, US T-Bonds, German Bunds and Gold. It is too early to suggest that part deux of the Euro crisis is upon us, but it is clear that much needs to be done to keep the Euro treaty, and the whole Eurozone project, on track.

GAME over

Following the suspension of GAME Group's shares yesterday, it appears that the major retailer of video games will become the next high profile retail casualty, following in the wake of the likes of Woolworths, Oddbins and Focus DIY.

Yet again, it appears that a combination of savvy shoppers willing to buy goods online rather than through a bricks and mortar retailer, together with increasing rents and weak consumer demand are behind their demise. In addition, GAME has also had to deal with the increase in digital delivery for games through systems such as Steam and Origin, which allow gamers to buy games online and download the code without the need to physically purchase a DVD copy. In a way, this is no different to the challenge iTunes poses traditional music and entertainment retailers, such as HMV.

I have been warning investors for some time that retail stocks are not in great shape generally, and whilst some, such as John Lewis, continue to post impressive results, others may find 2012 to be just as tough as last year. It is likely that the extended Sunday trading hours during the Olympics, and expected surge in spending around the Jubilee may help a little, so long as household budgets remain so constrained - at least from an investment viewpoint - there are better sectors in which to invest.

Are we still on the right course?

In the Budget speech yesterday, George Osborne delivered a fairly punchy statement, and one that may help sustain the very fragile recovery in the UK economy.
The increase in the Personal Allowance from £7,475 to £8,105 from next month and £9,205 in April 2013, should put a little more in consumer's pockets, so this may be marginally good news for the beleaguered High Street. Of course, those consumers will be paying more to fill up their cars from August, with the 3p increase in fuel duty confirmed, which will negate some of the positive effect. Also, the freezing of the age allowance, whilst not a tax hike on the elderly, may have an adverse effect on those whave retired or are nearing retirement.

In terms of the bigger picture, the UK economy is in a little better health than a year ago, and slow but steady progress appears to have been made. Borrowing in the 2011-12 is expected to be £126bn, £9bn than the year previous and a little ahead of estimates. There will also be a further boost to the public purse when the Royal Mail Pension Plan transfers to private ownership. George Osborne expects Consumer Price Inflation to fall below the 2% target by the end of 2012 (which, in my opinion, may be a little optimistic due to oil prices) and has reaffirmed the 2% level as being the long term target for the Bank of England, together with a continuation of the Asset purchase programme in the 2012-13 Tax Year.

Osborne has also signalled the possibility of the Debt Management Office issuing Gilts with a duration of greater than 50 years, and even possibly irredeemable, to lock in to the low Gilt yields at present. This seems a prudent move, though much depends on the ability for the UK Government to retain the AAA status from credit rating agencies, which is currently under threat.

Overall, for thematic investors, I do not believe the Budget included any profound changes. Clearly there was no shift in the policy of low inflation, low interest rates, and I continue to expect Base Rates to stay unchanged to at least 2013. Consumer stocks may benefit slightly from the tinkering with the personal allowances, but for Equities, I continue to favour defensive positions. Steady as she goes, at least for the time being, although factors beyond the control of either the Government or Central Banks, such as a further spike in oil prices, could yet jolt the fragile recovery.

The Great Recapitalisation

The Bank of England has now left the Base Interest Rate unchanged at 0.5% for 3 years. As I have commented in previous posts, this is noteworthy not only for the fact that this rate is the lowest ever set by the Bank in their 300 year history, but it is also highly unusual for the rate to be kept stable for such a length of time. (Of course, in the background, the Bank have been effectively lower rates even further by the programme of Quantitative Easing).


My view remains that the Bank of England will keep the Base Rate at 0.5% for the rest of 2012 at least, and you would have thought this would give some comfort to the millions of mortgage account holders. However, events over the last couple of weeks has shown a growing disconnect between the Base Rate and the "real" rate as set by the London Interbank Rate, or LIBOR for short.


As tensions begin to rise once again over the almost inevitable Greek default, so does the mistrust, and Banks are having to pay more to borrow money to lend on to mortgages and loans. On top of the funding requirements, banks have been ordered to shore up their financial strength and recapitalise under the terms of the Basel III Accord.


Citing the increase in funding costs, Royal Bank of Scotland, Halifax and Bank of Ireland have all signalled they intend to increase the Standard Variable Mortgage Rate (or SVR) over the next few months. RBS were the first to announce an increase, from 3.5% to 3.99%, followed by Halifax, who have announced that the "cap" on their SVR would also increase by a similar amount. Yesterday, Bank of Ireland announced that their SVR would increase from 2.99% to 3.99% and then to 4.49% by September, hiking mortgage payments by as much as 65%. I suspect that other Banks will follow suit in due course.


Many affected mortgage holders will be able to move to other Banks or find new deals, but a fair percentage will be unable to, due to the stricter lending criteria now in place.


It is clear that SVR's of 3% are not sustainable in the long term, and the Banks do need to go some way to repair the damage of the last four years, and by increasing the margin over and above deposits will assist in this regard. It is also possible that savers may at last get a little joy as Banks compete for deposits by offering interest rates that are a little more tempting than the last three years.


That said, from a macro-economic viewpoint, I believe these early interest rate hikes to be dangerous, and quite likely to derail the very tentative UK economic recovery. Hard pressed consumers are already faced with above inflation increases in Gas, Electricity, Petrol and food prices. Add a hike in the monthly mortgage payment in the mix, coupled with static incomes, and it is fairly evident that consumer discretionary spending may suffer as 2012 progresses.

2012 - Where Best to Invest?

For many investors, 2011 was a tough year, with many asset classes falling in value. With the Eurozone crisis rumbling on into  a third year, and economic growth anaemic in most Western economies, one could be forgiven for writing 2012 off as another year to forget. I do believe that there are, however, subtle differences that could lead to this year being more fruitful for the nimble investor. This is my take on where the major asset classes will be heading during this year - remember this is my opinion only and you should do you own research or seek the advice of a suitably qualified professional before taking any investment decision

Equities (Company Shares)

2011 saw the FTSE100 fall by 5% over the course of the year. As ever, the headline return only tells part of the story, and companies with strong cash flow and earnings, together with a defensive slant, performed best, which is a trend we see continuing this year. Expect Pharmaceuticals and Utilities to outperform, together with a resurgence in Mining and Energy companies, which largely disconnected from increases in the price of underlying commodities during the Autumn of last year. Sectors to avoid are retail and consumer discretionary, which may well endure a difficult year ahead. US Equities appear to offer modest value, and with the US economy seemingly regaining some poise, expect the US to lead the way during the year. Japanese Equities are a interesting proposition, with the massive re-structuring taking place following the earthquake and tsunami in March.

UK Gilts

Gilts were one of the success stories of 2011. Austerity measures implemented by the coalition government, whilst not universally applauded, appear to cement the UK’s position as a safe haven. As a result, 10 year Gilt yields have now fallen to just over 2%. It is unlikely that Gilt yields can fall much further from here and whilst we do not expect a jump in yields any time soon, the bull run for Gilts may be nearing an end.

Corporate Bonds

The Corporate Bond market endured a difficult second half of 2011, as even investment grade issues were caught in the backwash of the late Summer meltdown. Despite this period of weakness, the prospects for investment grade Corporate Bonds remain good for 2012. Underlying interest rates remain low, inflation is likely to fall back slightly over the course of the year and default rates are not showing any sign of a marked increase. Whilst the yields on Bonds issued by financials remain most tempting, we believe exposure to financial Bonds should continue to be limited, given the ongoing concerns over credit quality and the prospects of a disorderly break-up of the Eurozone.

High Yield Corporate Bonds

Higher yielding issues were volatile during 2011; however, a combination of historically low default rates and attractive yields suggests that this may be an asset class that outperforms during 2012. As ever, any extended period of weakness in Equities markets will dampen the performance.

Commodities (Gold / Oil)

During 2011, Gold prices surged to record highs as investors flocked to the precious metal as a hedge against both inflation and the potential for further fallout from the Eurozone crisis. Gold prices have fallen by around 13% from their 2011 peak, and we consider this to be overdone, given the fact that a cure for the Eurozone crisis is yet to be found. Oil prices drifted gently higher during 2011 and moderately higher demand should support prices around current levels in 2012. Any significant unrest in the Middle East, notably in Iran, could see a sharp spike in prices.

Property

Residential property prices generally fell during 2011 and with mortgage lending still restrained, I do not expect this trend to reverse during 2012. Low interest rates should lend some support to the market; however, with increasing unemployment and affordability still an issue, expect another difficult year for the UK housing market. Commercial Property is a little more attractive, but remains vulnerable to further economic downturn.

IMPORTANT - PLEASE NOTE THAT AS EVER YOU SHOULD SEEK INDEPENDENT INVESTMENT ADVICE , TAILORED TO YOUR CIRCUMSTANCES, BEFORE TAKING ANY INVESTMENT DECISION

Where next for the UK Economy

It has now been eighteen months since the coalition austerity measures were introduced, and since then the UK has experienced only one quarter of negative growth, which in itself is not enough to meet the technical definition of a recession (two successive quarters of negative growth). That said, growth in the other quarters has been barely visible, with the latest print for the 3^rd Quarter of 2011 coming in at 0.5%. Some analysts predict that the 4^th Quarter of 2011 saw the UK return to negative growth and we will know next month whether this was the case. I suspect that it will be a close call, but we may do enough to just continue in positive territory. In reality, the semantics of whether we avoid a technical recession or not is largely irrelevant, as for many people it certainly feels like we remain in recessionary conditions. And it is easy to see why.

UK Unemployment continues to climb, reaching 2.64m in December, a level not seen since 1994. With job security a key factor for many, it is hardly surprising that this has had a knock on effect on consumer spending, and the willingness of people to borrow to fund major purchases. Christmas 2011 was described as being a “critical” moment for many UK retailers and the consensus is that general spending was fairly lacklustre. With La Senza, Past Times and Blacks Leisure confirmed casualties over the festive period, and Peacocks/Bon Marche, Game and others on the ropes, it will take a major change in fortune if these chains are to survive the year unscathed. Even supermarket giant Tesco suffered a marked slowdown in sales and warned that profits would come in at the lower end of estimates.

The housing market was generally flat throughout 2011, and (according to Nationwide data) house prices in the UK were over 10% lower than at the peak in mid 2007. Despite historic low interest rates, which should bolster the housing market, the mortgage famine continues. Lenders continue to demand bigger deposits, with figures from the Council of Mortgage Lenders (CML) suggesting that the majority of borrowers now put down deposits of 20% or more.

Amidst all the apparent gloom, one has to wonder what Politicians and policymakers can do to improve the UK’s fortunes? In short, very little, as the necessary austerity drive has given them little room for manoeuvre, either fiscally or through monetary policy. The Bank of England has kept Base Interest Rates at 0.5% since March 2009, and has increased the Quantitative Easing programme to £275bn. It is highly unlikely that the Bank of England will increase rates any time soon, particularly given the fact that Inflation is beginning to ease. Annual CPI inflation fell to 4.2% in December, and with the recent cuts in energy prices announced over the past two weeks, and the effect of the VAT increase being removed from the annual calculations, I expect CPI inflation to moderate to around 3% by the end of the year.

Tax cuts, whilst generally positive from a popularity angle, do not fit with the general austerity message, and the March Budget will undoubtedly be one that aims to reinforce the austerity measures put in place in 2010.   In short, patience will be needed, and it may be at least another twelve months before we see the UK economy on a firmer footing.

There are however reasons to be cheerful, particularly if one looks at the fortunes of some of our European neighbours. We are now one of just 14 countries Worldwide to retain the AAA rating from S&P, and this has kept our borrowing costs relatively low, despite our high debt to GDP ratio. Whether we retain the AAA rating in the long term depends on whether the austerity measures begin to deliver the benefits of debt reduction, without damaging the prospects for economic growth.

Economic forecasting is a notoriously difficult job, but we suggest that, on balance, the UK will avoid slipping back into recession during 2012. Growth will probably remain slow (in the region of 1.5% to 2.5%) and we expect unemployment to continue to be elevated throughout the year. We further expect inflation to moderate, and also expect no action from the Bank of England on Interest Rates. As with 2011, much depends on whether real progress can be made in tackling the issues facing the Eurozone crisis – this is in the hands of the politicians, something that markets aren’t overly comfortable with.