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St. James's Place - Wealth Management - Market Bulletin - Monday September 12, 2011

Market Eye

Financial markets remained volatile last week, buffeted by good and bad news alike, as investors

endeavoured to price in more positive data from China versus deteriorating confidence in the

eurozone.

The larger than expected fiscal stimulus from President Obama to boost the US

economy found itself squeezed in the middle as markets gave a surprisingly scant and dismissive

response. After a shaky start to the week, global equity markets got back on the front foot, buoyed

by a decision of Germany’s constitutional court to support the government’s bail-out of stricken

eurozone countries. Whilst not unexpected, it raised hopes that the pending bail-out of Greece

would be completed and that powers giving the European stability fund (EFSF) to buy sovereign

bonds, recapitalise banks and issue ‘precautionary’ loans to eurozone members facing liquidity

problems would bolster markets. With worries about the eurozone temporarily abating, traders

turned their focus back onto economic fundamentals. Some better news from the eurozone showed

that German industrial production had jumped 4% in July – well ahead of expectations – and the

latest data from China showed imports increasing on the back of strong domestic demand.

But the eurozone crisis grabbed the headlines again on Friday on news that Jurgen Stark, a member

of the European Central Bank’s executive board and its chief economist, was resigning for

‘personal reasons’. There was speculation that he had quit over a row about the ECB’s bondbuying

strategy: the bank has been buying Italian and Spanish sovereign debt to restore confidence

in the markets and reduce the borrowing costs for the two countries. Mr Stark, who has the support

of other German policymakers, is opposed to the current policy. Coupled with comments from the

ECB’s president, Jean-Claude Trichet, who signalled that the bank was about to make a strategic

U-turn by cutting interest rates in the face of deteriorating global economic prospects, this was

enough to send the euro tumbling. The currency markets had already been stunned earlier in the

week when the Swiss National Bank (SNB) said it was setting a ceiling for the Swiss franc against

the euro in a desperate attempt to prevent the strength of its currency pushing the country into

recession. The Swiss franc has been a perceived haven in recent times and heavy buying has

pushed up its value to a point where the SNB believed it was massively overvalued. The efficacy

of such a move and the SNB’s resolve is likely to be tested in coming weeks.

The Way Ahead

So by the end of the week most of the major stock market indices had retreated as investors

weighed up the outlook for the global economy, corporate profits and most crucially the

effectiveness of politicians in tackling two key issues; resolving the eurozone debt crisis once and

for all and how to stimulate economic growth in the West – particularly the US – whilst at the

same time trying to bring government budget deficits back under control. To date, policymakers

have been relying on loose monetary policies (ultra-low interest rates), quantitative easing

(printing money) and stimulus packages to boost the economy. However, at the same time many

governments have already embarked on austerity measures (with the US being the exception),

relying on economic growth to help repair their balance sheets. Now that growth is slipping away

the markets are expecting decisive action from policymakers to get growth back on track and

Monday 12 September 2011

quickly. Recent stock market volatility is less about corporate earnings – which are mostly robust –

and the health of businesses but more about the lack of political direction and resolution of the key

issues outlined above. It is worth spending some time looking at the choices available and possible

outcomes.

Monetary Policy Committee Holds Firm

Here at home last week, the Bank of England held interest rates at their current rock-bottom rate of

0.5% - again no surprise given the comments made by the BoE’s governor, Mervyn King, a few

weeks ago that ultra-low borrowing rates are likely to be with us for the next 18 months or so. The

one aspect that did disappoint was no mention of a further round of QE (quantitative easing) –

some observers had hoped that the current low growth environment in the UK would cause the

MPC to respond with new asset purchases. Others, such as the likes of the Institute of Directors,

were also keen for the MPC to provide a boost for morale with more QE. So why no action? For

every business group that would have cheered, there might have been economists and investors

panicking that the MPC knew something they didn't - that the prospects for the recovery were even

worse than previously thought. That is what makes central bank surprises so risky. So for now Mr

King prefers to maintain a softly, softly approach to change.

There's another, more important, reason why the MPC probably held off. In his recent speeches

and press conference appearances, Mervyn King has spoken at length about the difficult period of

restructuring that lies ahead for the global economy, and the need for politicians to grapple with

the consequences of years of imbalanced growth and excessive accumulation of debt (by

consumers and governments). With record-low interest rates and emergency cash, he and his

colleagues at the ECB think they have helped buy some time for those imbalances to be worked

out. But central banks can't make those challenges go away. And they certainly can't magically

summon a strong global recovery, by simply firing off another barrel-load of cash. There is a view

that the MPC may go for more QE later in the year but, in doing so, they would need to be

confident that the economy was truly heading downhill, and we were not simply looking at a

prolonged period of disappointing growth. It is worth remembering that the UK economy is still

growing, albeit slowly, and is likely to achieve a c.1.0% increase in GDP this year. Against this

backdrop, George Osborne has maintained his resolve to stick to spending cuts, arguing that any

U-turns will undermine confidence and send gilt yields higher as has happened in the eurozone

periphery.

Obama Pledges to Boost US Economy

Last week President Obama announced plans to boost the US economy by proposing $447 billion

in tax cuts and new spending - a much larger push by the White House to rekindle growth in the

world’s largest economy. The plan includes a reduction in the Social Security payroll tax next year

for workers to 3.1% (from the current 4.2%); an establishment of an infrastructure bank and some

$80bn in spending on new building projects. Reflecting fears that a new global economic

slowdown was under way US Treasury Secretary, Tim Geithner, urged politicians and central

bankers to cast aside “political paralysis [and] misplaced fears about inflation and moral hazard”.

Whilst the measures will, if implemented, undeniably boost the economy, there is one major

stumbling block; the plan relies in large part on hopes of winning support from Republican

lawmakers who control the House of Representatives. The Republicans recently forced Mr

Obama’s hand in the debt-ceiling debacle to undertake cuts to the US deficit totalling $1,200bn so

it is unclear how the President’s jobs plan will correlate to these separate negotiations and how

they will be paid for.

The objection to issuing even more debt is understandable – the American electorate have made

their dislike of this approach keenly felt. However there is one school of economists including

Martin Wolf, who believe the markets are sending a clear message to governments to borrow and

spend. He argues that so long as private and foreign sectors run huge surpluses some governments

must find it easy to borrow and the only question is which ones? Yields on bonds issued by the

US, the UK and Germany have all tumbled in recent weeks as investors around the world flock to

buy them – in the case of the US and Germany yields on ten-year benchmark bonds are below

2.0% (fifty year lows). One of the arguments against government borrowing is that once it reaches

a certain level (90% of GDP is text book) growth slows sharply but, counters Wolfe, if you take

the UK, public debt was 260% in 1815 and the Industrial Revolution followed. What matters most

he said is how borrowing is used. Mr Wolfe concluded that fiscal policy is not exhausted and the

need is to combine the borrowing of cheap funds now with credible curbs on spending in the

longer term. The problem is that as the Western consumer deleverages and too large a part of the

world saves too much, the last thing needed is for creditworthy governments to slash their

borrowings.

Euro ‘will not fail’

So promised Angela Merkel, German chancellor, last Wednesday as she welcomed the country’s

constitutional court ruling as “absolutely confirming” her government’s policy of “solidarity with

individual responsibility”. She went on to say that Germany would continue to demand drastic debt

reduction from its eurozone partners in exchange for providing them with financial guarantees.

This means that once additional powers for the EFSF are approved, Germany will raise the scale of

its financial guarantees from €123bn to €211bn. The extent of the markets’ power should not be

underestimated and incurring its displeasure has, as we’ve seen in the last year, been very costly

for the likes of Greece et al. Last week, Silvio Berlusconi’s government caved into pressure from

the bond markets and European partners by announcing a last-minute U-turn to strengthen Italy’s

proposed austerity package. But investors are still nervous about the resolve of governments to

follow through their promises and matters, as said earlier, were not helped by the resignation of Mr

Stark from the ECB last week, which highlighted a divide in the bank’s senior management team.

Germany’s successor has been announced as Jorg Asmussen, its top international trouble-shooter

in the financial crisis. The move is seen as a bid to reassure both financial markets and domestic

opinion, shocked by last week’s sudden resignation.

The resolution of the current eurozone crisis is clearly an imperative yet judging market reactions

in recent weeks it would appear that financial markets are not wholly convinced. So what are the

other alternatives? Some investors still believe Greece will default, including veteran UK equity

manager Neil Woodford who has long held the view that the country will renege on its debt but

also that such a move “would probably be the biggest buy-signal ever for equity markets”. Is such

a move likely? Well, there are members of the eurozone who believe that expulsion from the

eurozone has to be the final penalty and that the region must return to the anchors of the eurozone.

Writing in The Financial Times the Netherlands Prime Minister and Finance Minister argued that

the rules – set out in the stability and growth pact - are still valid but all the participants must abide

by them. They proposed independent supervision of compliance with budgetary rules coupled with

tougher sanctions for those countries that infringe the rules, including preventive supervision.

Ultimately, they said, countries that do not want to submit to such a regime can leave the eurozone.

The problem today is that this choice is not part of the European Treaty.

What might the implications be if say Greece were to exit the eurozone? Economist Roger Bootle

argues that any plans would involve extreme secrecy so that investors didn’t withdraw money from

vulnerable countries’ banks as this could prompt a collapse and further crisis. He also said though

that, whilst an exit might be messy, the notion that such difficulties will prevent a country leaving

is absurd – the practicalities are that existing debt would be converted to the new domestic

currency along with some sort of default. The new currency would almost certainly fall below the

conversion rate (from the euro) on the exchanges, which is where much of the advantage would

lie. At a stroke, it would be possible to lower the country’s price level compared to the rest of the

eurozone and the outside world. Prices would rise but providing this was less than the devaluation

then this could open up the possibility of escape through economic growth driven by net exports.

This happened to the UK in 1992 after sterling’s major fall. For now though investors remain

nervous, waiting for decisive action on the part of the authorities

Banks Face Re-Organisation

UK banks should ring-fence their retail banking divisions to protect them from riskier investment

banking arms, a government-backed commission has announced today. The Independent

Commission on Banking, led by Sir John Vickers, said it would "make it easier and less costly to

resolve banks that get into trouble". The ICB called for the changes to be implemented by the start

of 2019. Chancellor George Osborne welcomed the "good" report and said he planned to stick to

the timetable it recommended. The changes have been well-trailed but originally the timetable was

shorter with the changes to be implemented by 2015.

A Fund Manager’s View

With volatility running at elevated levels many investors have, sensibly, taken little or no action in

respect of their investments, leaving the more challenging day-to-day decisions to investment

professionals. Nick Purves of RWC is a UK equity income manager with a value bias – seeking

out fundamentally sound businesses which are, for whatever reason, out of favour with the broad

market. “The portfolio continues to be defensively structured, with 31 stocks – all high quality

companies that are profitable and well-run. When choosing stocks I look at the valuation and

weigh up the risks but I do take a long-term view. Today, valuations are low, income yields are

very attractive – the portfolio yields almost 5% (net of basic rate tax) and dividends look secure.

The companies I own are mostly non-domestically facing – in other words they derive most of

their earnings from overseas, including emerging markets.

“I have consciously chosen to invest in liquid stocks where I can buy and sell relatively easily.

Generally liquidity in the markets is very low, especially if outside the top one hundred stocks. So

for safety I own many blue-chips such as Vodafone, Glaxo, Unilver, BSkyB and Tesco. The latter

is newly acquired following my exit from banking stocks. Investors will have made money out of

these in my portfolio but I made a decision recently, because of changing fundamentals, that there

were less risky ways of earning good returns on capital. I think the outlook for dividends is

positive. I expect them to grow at the long-run rate of 4%-5% which should outpace inflation. I

have been disappointed with the portfolio’s performance in recent weeks – it has for the most part

gone down in line with the market which is surprising given the defensive nature of the companies

I own. However, we are currently witnessing an unusually high level of correlation between the

movements of large cap stocks – 81% of shares are moving in the same direction against an

historical average of 30%. But with a high starting yield of 5% I think investors are being paid to

be patient whilst we wait for value to come from the underlying high-quality assets”.

Nick Purves manages funds for St. James’s Place.

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