The Global Month Ahead – An insight into December from 7IM

Financial News

In our regular feature Seven Investment Management (7IM) look forward to what the month ahead might hold.

United Kingdom – Fixed Income

Outlook Key Issues
The IMF studied past fiscal retrenchments internationally and found that those countries that focused, not on tax increases, but on spending cuts, especially “transfers and public wages”, were most effective.

Countries that followed this tough path enjoyed better growth and lower unemployment over 5-8 years. The IMF believes that the UK’s spending plans are consistent with the key qualities of past successful adjustments.

With the Inflation Report predicting above target inflation for at least another year, gilt investors are remarkably patient in accepting a payout of only around 3.5% – below the present rate of RPI. Global and UK growth has been strong, commodity prices robust, and wage growth is picking up, so something may give – short term rates have to go up or gilt prices fall as inflation erodes their value.
The Irish banks have to sell their non-core operations as they struggle to survive. Allied Irish in the UK is so badly regarded there were no takers though. The cry that “the banks are not lending” is correct for the Irish banks in the UK. Nationalisation by the Irish government is unlikely to change much.
The Greek crisis bought about a rally in gilt prices. The Irish crisis has not seen a similar rally, perhaps the reverse as gilts prices have been weak. Gilts were seen as a safe haven, but maybe stubbornly high inflation and attractive alternatives have diminished their attraction, perhaps rightly.

United Kingdom – Equities

Outlook Key Issues
A consistent theme this month is the knock on effect of the new round of Quantitative Easing (QE2). As the US Dollar falls, commodity prices rise. The UK stock market, with a large weighting in commodity stocks, has been a particular beneficiary as commodity profits soar, for now.
BHP Billiton’s bid for Potash Corp has been withdrawn, leaving the company nearly debt free and forecast to generate $10Bn+ a year in cash. The company has reactivated its £4.2bn buyback plan, but it may be tempted into an expensive acquisition, perhaps in energy.
Rio, which overpaid for Alcan in 2007 and had a crisis rights issue in 2009, is back on the acquisition trail looking for targets in copper and iron ore. Mining companies have too much money and remain convinced that they can add value by acquisitions whereas history suggests otherwise.
One-off, completely unpredictable events have recently laid low two of the UK’s top companies – BP (Macondo) and Rolls Royce (engine failure). One-off events, known as specific risk events in academia illustrate the need for a properly diversified portfolio now more than ever.
Another one-off event has hit De La Rue, the printer of bank notes. Its major customer is threatening to cut it after lapses in quality control. The stock price is off nearly 45% as a result of this one lapse. A new CEO is sought to re-establish and clean up its tarnished reputation.
Gartmore has put itself up for sale following the departure of star portfolio managers who were responsible for a disproportionate part of profits. This crisis was slightly more predictable and was a focus at the recent IPO. It shows the need for a sensibly balanced business model also.

North America

Outlook Key Issues
The Federal Reserve (the Fed) was set up in 1913 to safeguard against financial panics. Its other roles include price stability and to promote jobs. With QE2 some say the Fed now has a central planning role of trying to steer GDP at the risk of inflation and the expense of the real value of the $.
With the Fed printing Dollars under QE2, and devaluing the currency, why aren’t bond yields rising to compensate for the risk of inflation? Bonds, despite inflationary risks, continue to perform well and money floods into bond funds. Some see this as a bubble that will end in tears.
US corporate profits rose to an all time high during the third quarter 2010 to an annualised rate of $1.67 trillion, up 28.2% year on year. Strong foreign markets & cost cutting helped, but these figures suggest that future Earnings per Share (EPS) growth will be tough, which may slow the stock market.
The George Bush initiated tax cuts on dividends, higher earners and capital gains are due to expire in December. Obama is willing to speak to the Republicans to roll some of the tax cuts forward, but there is a lot of horse trading to do yet.
Fast growing US retailers J Crew and Gymboree have been acquired in two separate deals by private equity for a combined sum of $5Bn. A return to excess or is there real value in the market? The difficulty in borrowing suggests there might be value and maybe more deals to come.

Europe ex UK

Outlook Key Issues
Germany’s Chancellor Merkel made it clear that it wants changes to the EU Treaty so that its crisis resolution process has an orderly default mechanism that is “legally unchallengeable”. Germany does not want to bail out the rest of the EU. Negotiations will be long, but it will get its way, with the effect that Germany’s financial discipline will be imposed on the rest of Europe or they will be out of the Euro.
After the markets have attacked the cost of debt for Greece, Ireland and Spain, they could now turn on the big economies of Italy and France. This is reminiscent of the break-up of the EMU in 1992. Spain, Italy, Ireland and the UK got kicked out, but France held on at huge financial cost. Do they know what they are letting themselves in for?
Estonia adopts the Euro on the 1st January 2011. None of these are strong, stand alone businesses, but they are benefitting from the booming emerging markets and a charismatic CEO.
Fiat is splitting itself into 2 listed entities, Auto (incl. Ferrari, Alfa Romeo & a stake in Chrysler) and Industrial (incl. trucks & agricultural equipment). VW has tried to buy Alfa Romeo before, could it try again? VW could give Alfa the scale and investment it needs to recover from years of losses.
VW is booming and announced that it will invest €52Bn by 2015 with all of it going into capex and R&D and an additional €11Bn invested in China. Traditionally a great leading indicator. Core Europe is doing well.
The German IFO survey of industrial confidence hit an all time high.

Other Markets

Outlook Key Issues
The Chinese, by pegging their currency to the US Dollar, also get US low interest rates, which are not appropriate for their booming economy. The deputy governor of the People’s Bank of China said that the Fed’s QE2 programme “could also stir the formation of asset bubbles”. You are warned.
Chinese inflation jumped to 4.4% in October, or 12.1% annualised. This is well above the government’s 3% target. The government may have take action, which may ultimately include breaking the link to the US Dollar. The cheap Chinese currency, low rates, rapid growth and commodity prices are feeding domestic inflation. An aim of the US’s QE2 is to force up the Chinese currency. China may have to tolerate high inflation otherwise.
Many emerging markets are suffering from asset bubbles stoked by foreign capital inflows, and low interest rates. Room for these countries to manoeuvre is limited while they maintain the USD peg. Korea is the latest to impose capital controls to slow foreign money and the Hong Kong government has taken action to cool its property market. More will take action as the impact of QE2 spreads out beyond the US.
Boosted by expiring tax breaks on cars, the Japanese economy grew at a faster than expected pace of 3.6% annualised during Q3 2010. The Bank of Japan deputy governor says he is ready to act with more Japanese QE if there are clear signs of a downturn or deflation.

Present Situation Next Meeting Expectation Source
Bank of England 0.5% 14 December QE2 Seems dead now Click here
US Federal reserve 0% – 0.25%

13 December

QE2 has started and is set to continue Click here
European Central Bank 1.0% 2 December On hold for now Click here

The views expressed in this document are for information only and do not constitute investment advice.

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