Investment Update

August 2011

Markets in turmoil

The unprecedented decision by Standard & Poor´s to downgrade America´s credit rating from AAA to AA+ was the straw that broke the camel´s back, shattering investor confidence and sending global stockmarkets into panic.

The downgrade unleashed a wave of criticism upon the ratings agency themselves from the US Government, the Federal Reserve and a number of fund managers such as Bill Miller, Chief Investment Officer at Legg Mason Capital who, writing in the Financial Times, claimed S&P "showed a stunning ignorance and disregard for the potential consequences on a fragile global financial system". It seems that S&P just can´t win – it was the ratings agencies who were blamed when the banks were going bust in 2008 for not conducting independent and accurate analysis on the securitised sub – prime mortgages that were being used as investment grade collateral security for further lending.

The point is that no–one really wants to hear bad economic news, particularly the politicians, central bankers and financial media who have been in a state of continual denial on the severity of the financial crisis and its long–term implications.

According to former IMF Chief Economist Professor Kenneth Rogoff (co–author of ‘This time is Different— Eight Centuries of Financial Folly´); "the downgrade was deserved; S&P called a spade a spade". When questioned as to whether the US now faced a double dip recession, he answered "it´s beside the point; we are still in…the Great Contraction".

The US Federal Reserve has responded to the stockmarket collapse by announcing that it will keep interest rates at their current historic low level for a further two years – confirmation in itself that the economy has no traction for growth. They have also opened the door for further Quantitative Easing.

All the Central Bankers and Politicians have become ‘Keynesians´, whereby they believe that they hold the tools and have the levers to solve the problems; creating jobs, prosperity and growth. The reality is that QE1 and QE2 have done nothing for job creation and economic growth; it has added to the debt of Western Nations and in the process made the wealthy elite even wealthier.

The USA was never going to default on its debt; it doesn´t need to. As the World´s Currency Reserve it can simply print more Dollars, in doing so it reduces the value of the Dollar and creates inflation. This is how Keynesian Central Bankers and politicians respond to economic problems. Even Professor Rogoff has called for "much more aggressive monetary policy...however unpopular".

We face the twin threats of deflation and inflation. Deflation, by way of less spending in the shops as people tighten their belts in response to their fears and concerns for the future, and less credit. Inflation in the form of rising core prices of food, energy and finished goods from abroad as governments print more paper money.

Greater Central Bank intervention and Government fiscal policies manipulate markets and misallocate resources and investment. In the end, no–one really knows what is true or fair value. Prices and asset values become distorted.

Consequently, investors are forced to take decisions that are outside of their usual level or risk. Perversely, the prices of US, UK and German Government debt is going up as fear takes hold, even though it is the level of government debt that has caused the fear in the first place.

With interest rates so low, should investors take advantage of the recent stockmarket falls? Are equities fair value today, after all companies are sitting on huge piles of cash and are making good profits?

Robert Prechter of Elliot Wave International notes, "In May 2011 the dividend yield on the Dow Jones Index of US shares was 2.3%. Equity investors argue that a 2.3% yield from blue chip shares is bullish because it is much bigger than the near–zero yield from Treasury bills (similar to UK Gilts), but this argument does not hold water. In June 1984, 12 month T–Bills yielded 12%, way more than stocks, but the difference was not bearish; the stock market took off from the upside from there".

As we have been saying all along, this is no ordinary recession; we remain in the aftermath of the most severe banking crisis since the 1930s, caused by an extraordinary accumulation of debt which allowed Western economies to live far beyond their means for nearly two decades. Now it is payback time and the payment will be in slower, possibly even stagnant economic growth and falling living standards for the great majority until the debt is reduced to more manageable levels. Unfortunately, this is going to take years and no amount of Government and Central Bank interference is going to change this process; they can only delay the inevitable and in doing so prolong the pain.

Writing in the Financial Times this week, Joseph Stiglitz, recipient of the 2001 Nobel Prize states "now the scale of the problem is apparent a new confidence has emerged: confidence that matters will get worse, whatever action we take. A long malaise now seems like the optimistic scenario".

Tim Price of Money Week notes "Markets have finally woken up to the problems facing the indebted Nations and complacency has been replaced by the sense of fear that the World has gone Ex–growth.

World stockmarkets are currently experiencing a bounce in response to the 20% decline that took them officially back into correction territory. The bull market cycle that started in March 2009 has ended and we have resumed the secular downtrend. It is highly likely that stockmarkets will fall further before they finally find their floor.

We expect a further round of QE within the next 6–9 months. Gold may take a short correction, but its long–term trajectory is assured with the US unprepared to defend the Dollar; we believe that it makes sense for all investors to hold some gold.

We believe the key objective remains one of capital preservation; investment diversification to include stronger currencies (including some Emerging Market currencies), index–linked gilts, short–dated gilts, cash and finally investment grade bonds all have a part to play in these difficult times.

 

If you would like to discuss your investments and any of the issues that we have mentioned, please contact us.

Steve Wilson BA(Hons) CertPFS, Certs CII(MP & ER)
Managing Partner
steve.wilson@2hwealthcare.co.uk

 

The above represent the views of the author and are not necessarily the views of all the partners of 2hwealthcare LLP. The content is for your general information and is not intended to address your particular requirements. It does not represent specific personal advice.