Investment Update

September 2010

Man of Destiny

The coalition Government recently completed their first 100 days in office. By signalling a clear intention to tackle the deficit problem, Chancellor George Osborne began the process of preparing the public for a period of austerity and cost cutting; the underlying objectives are to reduce UK public debt and maintain the UK’s AAA credit rating. So far, they have been given the thumbs-up by the bond markets. Sterling has rallied and the anticipated sell-off in UK gilts failed to materialise.

In fact we are seeing the exact opposite, in August the UK 10-year Gilt yield plunged to its lowest level on record, driving capital values higher. The UK is not alone, Government Bond records are tumbling worldwide – US short-dated bond and German bund yields are also at record lows.

The bond markets are anticipating lower GDP growth.

In the US, led by a spectacular collapse in housing sales, data is suggesting that the recovery has stalled; in fact it may not be so much ‘double-dip’ as ‘single-scoop’ to use David Rosenberg’s (chief economist of Gluskin Sheff) term. The recession never really ended. The ‘recovery’ to date has been a “result of inventory building and cost cutting”, which is not a basis for sustainable long-term growth.

In a ‘normal’ post-1945 recovery, four quarters in, GDP is steaming ahead at 6% per annum. But growth in the US slowed in the second quarter to 2.4% and Q3 may even come in at 0%. According to Rosenberg, the US economy will be “back in contraction by the fourth quarter of 2010”.

The fundamental reason for the weak economy is debt. Households in the US are up to the eyeballs in debt which is significant because consumption represents over 70% of the US economy.

The US household debt-income ratio peaked in Q1 2008 at 136%, today it is 126%. But the pre-bubble norm was 70%. To get the household debt down to a more normal ratio, private US debt would have to be reduced by $6 trillion. That is going to take a long time.

We are still in the early stages of a secular credit collapse of historical proportion. According to consultants McKinsey, the process of debt de-leveraging can take up to seven years after the initial financial crisis. We are only just beginning this process.

Likewise, Professor Carmen Reinhart (co-author of ‘This Time is Different – Eight Centuries of Financial Folly’) wrote an article in the FT on 30th August (from a paper presented at the recent Jackson Hole Symposium) warning of the premature optimism displayed by Central Bankers. “Post-crash, the ratio of credit to GDP declines by an amount comparable to the pre-crisis surge…..the need to de-leverage will dampen employment for some time to come”. The economy does not go back to ‘normal’ pre-crisis levels of activity, because pre-crisis activity was not ‘normal’. The crisis was the result of abnormal conditions such as too much debt, spending and speculation.

What we are starting to see is a fundamental shift in behavioural patterns of borrowing, spending and saving. The baby-boomers who led the way in consumer spending through the eighties and the nineties; fed by the monetary easing of Alan Greenspan and encouraged by the sight of their homes rising in value, are now beginning to fix their sights on shrinking the size of their debts as fast as they can. Retirement looms large with fewer years left to make up the shortfall in future income.

The post-war inflationary growth of asset prices was only possible with extraordinary and progressive credit growth. Today, the situation has reversed; lenders are reluctant to lend – they want to repair their balance sheets and only take on the best customers – and Government imposed lending targets won’t work. Steve Cooper, Barclays head of Small Business Division said last week that they “don’t want to create an expectation that if Barclays said no on Thursday it could say yes on Friday (because it has a target to achieve).”

The result will be an extended period of significant credit contraction, which is more of a worry to the Central Bankers than inflation because it lowers growth, raises unemployment, reduces the Government tax take and leads to falling asset prices.

Central Banks have a twin mandate; they target inflation (by way of stable prices) and full employment. In their ideal world they want a moderate amount of inflation. Because we have an asset based economy, mildly increasing prices and asset values offer credit expansion, fuelling GDP and employment.

What the Central Banks don’t want is credit contraction. So they intervene through monetary and fiscal policy (low interest rates and Quantitative Easing or money printing) in order to reflate asset values.

But, if the monetary policy and fiscal stimulus is not working, what are the Central Bankers going to do?

In Europe, the UK and Ireland are leading the way in a drive to cut the national debt by reining in spending. The danger is that this reduces overall demand in the economy, ushering in a period of austerity and economic stagnation.

In the USA, the demand is for more stimulus and more spending. Paul Krugman, the Princetown economist and winner of the Nobel Prize in Economics and regular columnist in the NY Times, has called the Federal Reserve Bank’s current policy “grossly inadequate” and “logically bizarre”. He argues that the Fed should already be buying more assets.

The Chairman of the Federal Reserve Bank is Ben Bernanke. In 2002 he delivered a speech to the Washington National Economists Club entitled “Deflation: making sure it doesn’t happen here”. His speech makes clear that he fears falling prices. The most cited paragraph from this speech is as follows: “Like gold, US dollars have value only to the extent they are strictly limited in supply. But the US Government has a technology called the printing press that allows it to produce as many US dollars as it wishes at essentially no cost”.

At the Jackson Hole Symposium last month, Mr Bernanke said that he expects the “economy to expand in the second half of 2010” and that “the pre-conditions for a pick-up in growth in 2011 remain in place”. More importantly, he also said “the issue at this stage is not whether we have the tools to help support economic activity and guard against disinflation, because we do”.

In the FT on Saturday, Robin Harding wrote that Mr Bernanke appeared to signal that he may soon take the “momentous step of leading his colleagues on the Federal Open Market Committee into a new round of quantitative easing”. That would mean pumping cash into the economy by buying billions of dollars of assets in an effort to boost activity”.

Mark Gertler, a long-time co-author with Mr Bernanke and professor at New York University recently commented “Everything I know about Bernanke is that his instinct is to be aggressive. There is no way on Earth that he wants to be the Fed chairman who lets the economy deteriorate”.

According to Fred Sheehan, author of ‘Panderer to Power – the untold story of how Alan Greenspan enriched Wall Street and left a legacy of recession’, at some point Ben Bernanke’s economic outlook will be untenable. “The Fed chairman is habitually slow to understand changing circumstances, but Dow 5,000 could do the trick”.

Maybe it does not need the Dow to fall by 50% to encourage Mr Bernanke to start cranking the printing press. If the US housing market translates falling sales into a fresh decline of house prices, it could drag the economy back into the negative GDP anticipated by David Rosenberg by the end of the year. That will force Mr Bernanke to change his optimistic view and unleash a new wave of stimulus.

In summary, de-leveraging is under way; it is a painful process that will lead to falling living standards for many. It is also a necessary process as it allows the economy to take the excess, accumulated during the frenzied bubble period, out of the system. This is turn sets the stage for the next period of growth.

The danger is when over-optimistic Central Bankers step in and pump more debt into an already over-inflated debt bubble. Mr Bernanke appears to be approaching his moment of destiny.

Implication for investors

These are dangerous times for investors. We continue to recommend capital preservation strategies. This is not the time for taking risk with your money. Furthermore, simple buy and hold investment strategies that worked in the post-war period up to 2000 cannot be relied upon. Since then, the Dow Jones Index has been on a roller coaster ride, with declines of 48% and 57% and a rally of 100% in between.

We advocate holding a large slice of a portfolio in 12 month term deposits, where it is possible to obtain circa 2.8% gross from a number of deposit takers such as Co-Operative Bank, Britannia and Santander. This also provides liquidity in the short-term which offers flexibility with the portfolio as the economic landscape changes.

For improved income, Investment Grade Corporate Bonds offer a better return than cash and government stocks. As the spread between Investment Grade Corporate Bonds and Gilts narrows, it opens up the potential for capital growth. We think the bull-run on bonds is not yet over, the trend for falling yields will continue for the time being.

Gold is generally considered a hedge against inflation, but also attracts attention in times of acute financial crisis and uncertainty with Government policy response. For the latter reason alone, we suggest at least a 10% allocation to gold.
Gold took a tumble in June and fell to $1138/oz in July, but importantly it never fell below its 30 day moving average price, where it found support. It has since recovered and is rapidly closing back in on its all time high of $1260/oz. We believe that gold has much further to go, although it will be highly volatile.

Finally, for clients who are willing to take a little extra risk, we suggest that they consider an ‘unconstrained’ or total return fund. These funds allow the fund manager investment freedom without being restricted or constrained by set parameters. In essence the success or failure of the overall return is determined by the fund manager’s view on the outlook for the economy and investment markets.

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

References:
FT.Com – various
Professors Carmen Reinhart and Kenneth Rogoff – ‘This time is different: eight centuries of financial folly’
The McKinsey Global Institute - ‘Debt and deleveraging: The global credit bubble and its economic consequences’
Edward Harrison – www.creditwritedowns.com
David A. Rosenberg – Chief economist and strategist Gluskin Sheff & Associate

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.