Evercore Pan Asset

This week saw the Spanish authorities seek to cut a further €10 billion from their public sector budgets, in an attempt to stave off further rises in their 10 year and other borrowing rates. The ECB rode to their rescue by saying it would consider buying more Spanish government debt, once the government had pledged more austerity. The problem remains intense in Spain, with 23% unemployment, no ability to devalue its own currency to try to price itself back into markets, and always at the mercy of the bond markets.

The UK is in contrast still enjoying low borrowing rates, thanks to a large quantitative easing and bond buying programme by the Central Bank. It is also seeking a recovery with more exports, following devaluation. It has lower unemployment and a competitive service sector which earns a healthy surplus. The London economy is relatively strong, attracting talent and capital from around the world.
 
The two countries do share some similar problems. Both experienced overextended credit and property bubbles. Both ended up with weak banks as a result of the Credit bubble excesses. Both have large public sector deficits and growing burdens of public debt. Both now have governments seeking to rein in those deficits primarily so far by tax rises, which in turn squeeze the private sector more.  The majority of the €27 billion of “cuts” in the latest Spanish budget took the form of more tax revenue or higher utility prices resulting in lower state subsidies, putting the squeeze on the private sector.
 
The UK yesterday published some disappointing trade figures. The private sector led recovery envisaged by the government requires a good improvement in overseas trade results. The February figures saw a £1 billion increase in the overall trade deficit from January, owing mainly to a fall in the export of goods. It is not wise to read too much into one month’s figures, but the deficits with both China and Germany remained large and the deterioration was worse outside the EU area. Fortunately services held steady with a strong £5.4 billion surplus to offset more than 60% of the goods deficit. Goods exporters pushed up prices, cutting some of the advantage of the devaluation, in response to increased energy and raw materials prices.
 
Rebalancing economies with balance of payments deficits, large state sectors, and slow or no growth is not easy. Trying to do so without the capacity to change the currency level or run your own credit and money policy is considerably more testing, as Spain is discovering.

We have seen the Euro crisis sweep aside governments in Greece and Italy, Ireland and Spain. Soon the French President faces re-election, whilst next year Frau Merkel needs to seek a new mandate. On May 6 2012 the Greek people get a chance to vote for a different administration. Could there be significant changes from these events?

Markets have got used to a double act between Merkel and Sarkozy. Whilst there have been some tensions between the two, they have worked reasonably well together. They are both mildly right of centre in a European sense. They are both strong protagonists of the Euro project, keen to keep it going. Both have accepted the German doctrine that austerity measures are needed to live within the disciplines of the Euro.

It is possible both are re-elected. Current polls show Mr Sarkozy a little ahead of the first round, though they suggest he will lose to his socialist opponent in the second round. The challenger, Mr Hollande, wants higher taxes on the rich and on enterprise and has said he wishes to renegotiate the austerity pact Treaty. If the French stick to their current intention to elect him there will be some choppiness in markets as they appraise his alternative approach and as the Germans are required to adjust their script to the different rhetoric of their new key ally.

Frau Merkel is popular herself, and is widely perceived as being the most powerful and important European continental politician. She may not, however, keep her job. It is possible a new Coalition between Greens and the Social Democrats in Germany will poll more votes than she and her failing partners, the Free Democrats. That will produce a change in how Germany approaches austerity and the EU. It too, like the possible election of a socialist in France, could lead to doubts about the current policy of stricter discipline on Euro members and whether it can be enforced or can work.

Meanwhile, present polls suggest Greece will elect a Coalition government on May 6th in a Parliament where MPs from the parties against the bailout packages are likely to outnumber the parties in favour. That could produce some lively exchanges between Greece and her bank managers. Whilst the generous loans from the ECB have so far calmed markets around the Euro, it would be wise to recognise that there could be unsettling changes ahead. The underlying economies of Spain, Greece, and Portugal remain very weak. To the average voter the austerity medicine is not working. This could prove destabilising.

The Office of Budget Responsibility has come up with new forecasts for the next few years for the UK economy.  They expect growth to accelerate next year, and then do well in 2014 to 2016. They did, of course, forecast better growth in 2011-12 in their original 2010 estimates, but have had to scale those back. They now expect growth of 0.8% this year, 2.0% next year, 2.7% in 2014 and 3% for each of the following two years. 

So where does the growth come from?  They anticipate much of it coming from increased household consumption as they expect average earnings to be rising well by the end of the period, in excess of CPI inflation. They also think business will increase investment and there will be a small positive from increased exports.  Since their November forecast they have become more bullish on the prospects for extra household spending, have revised up their forecast of government current spending and become more pessimistic about business investment. 

By 2016 the OBR thinks there will be 4% inflation as measured by the more traditional RPI, though still only 2% on the CPI. They expect wages and salaries to be rising by 5.6% and house prices to be increasing by 4.5%. 

I suspect the forecasts understate the contribution of public sector current spending to economic activity in the later years, as they understated it in the 2010 forecasts for this year and next. The OBR states “Government consumption looks to have made a positive contribution to growth in 2011 and is currently estimated to have grown by a little over 1% in real terms in the final quarter of the year…. the positive contributions from this component are still surprising” We do not share their surprise, as we have been forecasting such an outturn for some time. The current strategy for private sector led growth rests heavily on more substantial cuts in public spending in the second half of this planned five year Parliament to shift resources into the private sector.  It is possible that as the election approaches these cuts will be altered. 

The substantial increase in business investment still in the figures rests heavily on the growth in private sector incomes and consumption. It is possible that by the middle of the decade the easier money injected into the system will start to find its way into wage packets and spending. The forecast assumes easier money leads to more inflation and to more activity. The remaining problem is the state of the banks, and the persistent wish of the authorities for the banks to lend less to improve their capital ratios. 

The suggestion of higher RPI inflation is a worry for investors that needs to be taken into account.  Whilst we think public spending may be stronger than forecast, we are more cautious about the prospects for consumer led growth than the OBR. Meanwhile the deficit remains large, the government financing needs are still big, and interest rates are unlikely to fall further. The OBR forecasts rising gilt yields from here. They think the average conventional gilt rate of 2.2% will go up to 3.2% by 2014-15. We still advise investors to avoid gilts. For share investors there is still plenty of work to be done to shift the economy from its high dependence on the public sector and to increase the industrial share as the government wishes.

Last year we put the Italian 10 year bond rate onto our watched list for our daily meeting. This month we switched from the Italian to the Spanish 10 year yield.
 
We do not, of course, hold any Italian or Spanish bonds. We watch them closely because we do not think the Euro crisis is over. The current situation is the lull between the storms. Plenty of Central Bank lending to the commercial banks has bought the Euro area some more time to sort out the underlying problems, but has not taken the problems away.
 
Prior to the issue of two large tranches of money to the banks, it was the Italian bond yield that was rising further and faster than the Spanish one. Italy has a large overhang of debt which needs refinancing. Spain was treated more favourably, because electoral change to a government which believed in austerity was in the air.
 
Today markets are more nervous about Spain. The new Spanish government was duly elected, and did come in promising more austerity. It willingly signed the new budget control treaty. It then said the deficit was worse than it realised, that it would not hit the new tough targets, and it needed more time to get on top of the problem. This started to erode confidence in Spanish bonds. 
 
Spain has serious interlocking problems. Her banking system is one of the weaker ones when you look at the amount of banking capital in relation to loans. The banking system still has to deal with the overhang of a big property bubble, leaving people unsure about how many more losses will need to be written off. Meanwhile the economy is performing badly, with very high levels of unemployment. The lack of confidence in the economy makes the position of the banks more risky, which in turn makes them even more cautious about financing anything new. The advertised austerity plus budget designed to cut the deficit does not solve the problem of a lack of growth in the private sector. Somehow Spain needs new private sector jobs to boost incomes and tax revenues.
 
We have stayed out of risky Euro assets in this recent rally. The rises in the Spanish bond rates are a warning. We continue to believe there are better parts of the world with much better growth prospects for equity investors. Spanish bonds tell their own story of the continuing dangers of lending to some EU governments. The current Euro scheme leaves countries like Spain uncompetitive, forced to cut and cut again.

The Greek default has passed without undue apparent disruption to markets. Fears of a banking collapse proved wide of the mark. The banks which still own substantial quantities of Greek bonds had made earlier provision, or were capable of handling the fall out thanks to the generous low cost loans available from the European Central Bank. So far, so good.

The last set of stress tests for European banks reminded us that the banking systems of Greece, Spain, Ireland, Portugal and Italy have their problems. Ireland’s weakness has led to substantial state support and intervention. The future of the Irish banks and the state are now bound together. It was financial problems in the Irish banks which led to the trip to the IMF and EU for soft loans. Spain still struggles on without special help. In the European Banking Agency figures, Ireland had 3 banks with low capital ratios, and Spain 9, the two countries with most banks at risk prior to capital raising last year.

In the European Banking Agency assessment after capital raising Ireland had no banks at undue risk. Spain still had the most banks with low capital levels, with 5 banks below the threshold of a 5% Tier One Capital Ratio. Greece had two such banks. Spain also had 7 banks between 5% and 6%, Portugal 2, Greece 2 and Italy 1. There are also banks elsewhere in Europe that have quite low capital ratios.

These banks remain under some pressure to improve their balance sheets. They can do so by retaining profits. They can sell assets, and run down their loan books. They can go slow on new lending. They can try to raise money from shareholders. The net result of these requirements will be slower credit growth overall. The weak banks will not be able to help much with financing economic recovery.

Whilst it is good news that the European Central Bank has made so much money available, and good news the Greek default has passed off peacefully, it is not the end of the Euro troubles. Few believe Greece will be able to deliver the full improvements in its financial position demanded by its creditors. Many fear that weak banks around Euroland will reinforce the recessionary tendencies, which in turn weakens state finances more. The Euro area needs more growth. It needs rising tax revenue and more employment. Instead on current policies it faces constrained tax receipts, slow or no growth and high levels of unemployment. Spain has had to announce it cannot meet the new exacting deficit targets, and has a serious youth unemployment problem.

For the time being markets are reassured. The large sums released by the ECB are helping. We will still be watching Euro area developments carefully, as there is still no sign of a solution to the problems of falling output, high deficits and a lack of competitiveness in the weaker areas of the union. At best there will be slow growth in Europe, punctuated by fears about the finances of the weaker banks and states.

The budget cut a little from public spending to allow some overall cuts in Income tax. The forecast borrowing totals for the period up to 2014-15 came down a little from the large figures that were published in the Autumn Statement last year. In other words, the overall impact of the budget was small, shifting a few billions in a £1500 billion economy.
 
The intention of the budget is to rally business behind the government’s growth strategy. The aim is to shift resources from public sector to private, and to build up industrial sectors to complement the strength of the economy in financial services. The chosen methods are to expand credit, to cut taxes, and to drive through a large infrastructure programme.
 
The government and its financial regulators have fought shy of relaxing the current controls on banks. Though they say they now believe in counter cyclical regulation, they are still practising the ever popular pro cyclical variety. Today the demands for more cash and capital reinforce the deflationary tendencies. To offset the negative impact, the government has come up with a scheme to stimulate more mortgages, and another plan to ease credit for smaller and medium sized enterprises. These may help at the margin, but they do not represent a fix for the long and deep seated banking problems.
 
The tax package is attractive to larger businesses. The offshore companies regime has been made friendlier. The North Sea oil and gas regime is being tweaked back after last year’s increase, as they now want to stimulate more exploration and drilling. The eye catching cuts in Corporation Tax, to take it down to 22% by 2014, will be attractive to companies looking for a place to invest.
 
The decision to cut the 50% top rate of Income Tax to 45% is helpful. It comes in in 2013, not this year. It still leaves the UK at the high end on personal tax rates, at a time when personal rewards can lead to footloose talent. It is paid for several times over by a further tax foray into high end property, which will mainly hit offshore buyers of London homes. The Chancellor assumes they will come or stay and pay. He still needs them.
 
The infrastructure programme is work in progress. The scheme to add toll-roads alongside our state provided highways will take some months to work up and explain to a sceptical public. When it comes to extra London airport capacity, it is back to the drawing board for a new government policy. The wish to press on with new energy investment is further advanced. The Chancellor still has to do more to show business that he understands the problems high energy prices cause, especially for industry which may need to burn a lot.

The large increase in personal tax allowances for standard rate taxpayers goes alongside the 5% benefits and pension up-ratings to give a boost to incomes. This could help an economy struggling to grow again after the setback at the end of 2011. Every little helps. In view of the large public spending commitments this was as much as the Chancellor dare do without worrying the markets about the plan to cut the deficit.

We know most of the numbers for the UK budget. The Coalition government has long since set out a five year plan for the public finances. The government updated it again last November. The outlines of the plan remain clear. The government plans a slower rate of growth in cash public spending than in recent years. Over the five years as a whole the 2011 budget estimated an increase of 16%. This could be a small real decline, depending on success with controlling public sector wages and other costs. They planned a large increase in tax revenues, forecasting these to be 36% higher in 2014-15 than in 2009-10. This forecast was reduced in the Autumn Statement last November, when the Office of Budget Responsibility downgraded its growth forecasts for the economy.  
 
The 2012 budget is unlikely to make big shifts in the 5 year plan figures. The Office of Budget responsibility should not have to downgrade its growth figures again, given the changes made last November. The impression given is that the 2.5% increase in the VAT rate was the last big tax rise needed to meet the revenue targets. This budget will be about whether to not the government trims the 50% marginal Income Tax rate, depending on its view of whether a lower rate would bring in more revenue or less. It will also give the opportunity for the government to express a new view on future rises in petrol tax, given the way oil prices have moved up.
 
The budget will probably be dubbed a budget for growth. The government and their critics agree that the economy needs to grow more rapidly in order to deliver the tax revenue forecasts, and to help deliver the cuts in benefit expenditures when unemployment falls which the plan requires. We have already seen what looks like well informed comment on some of the options the government is proposing. The Prime Minister himself announced new plans to find ways to raise more private sector money to promote more infrastructure expenditure. The Treasury has unveiled cheaper money for banks to lend on to smaller and medium sized enterprises through Credit Easing. We learn that every taxpayer may be sent a guide to how much direct tax he or she pays and what it is spent on. Pension funds are being asked to invest more directly in infrastructure to help power recovery with more roads, water, electricity and other capacity. 
 
The problem remains that the banks are under strict regulatory controls which limits their ability to lend more to UK customers and the corporate sector. The Credit Easing proposals, on top of the government’s mortgage assistance, are designed to alleviate some of this tightness. The budget can help at the margins, but the broad outlines of the UK economy are defined by the Credit Crunch and by the large build up of public sector debt. The UK will remain under the long shadow of the banking crunch, and grappling with the problem of too large a debt and deficit, for some time to come. This budget will try to address the lack of growth. It will be judged by how strong a message it sends to investors and businesses that the UK is “open for business”. That is partly a question of words, and partly a question of tax rates and regulations. Meanwhile the Bank of England makes the large decisions on interest rates and quantitative easing, and intends to complete its £325 billion QE programme. The government’s budget task would become a lot more difficult if bond rates rose after the ending of this policy, forcing the government to find more money to pay the interest bills.

This week the UK’s announcement that the government is considering issuing 100 year bonds grabbed the headlines. The story was designed to highlight the favourable low rates of interest the UK government still enjoys when raising new funds. It also underwrote the helpful fact that UK government debt is already on average longer term than many EU countries, reducing the pressures on government as it needs less frequent refinancing. Less UK debt needs replacing each year than in comparable countries. If they do sell a decent amount of 100 year bonds, or offer more 50 year bonds, it continues to put off the day when the UK needs to replace a large amount of borrowing in a hurry.
 
The idea was to make this a good news story. Most will interpret it in this friendly way. However, it does serve as a reminder that the UK government is still borrowing very large additional sums. There is much muddled language around about “paying down the deficit” and about the strict austerity which is controlling the debt. The figures remind us that the debt is large and growing quickly. The government is trying to cut the rate of increase in borrowing, not to cut the debt. It reminds us just how much interest the state has to pay. Every £1,000 million of 100 year bond issued may cost taxpayers around £3,500 million in interest charges before repayment. That is all money which has to be collected in taxes sometime.
 
No-one knows for sure how much lower the interest rate on government debt is owing to the Bank’s Quantitative Easing programme. Given the Bank’s decision to buy up almost one third of the available stock of government bonds, you would expect that to have some important impact on the prices of the bonds, keeping yields low. The interest rates are also low owing to the deep recession the country passed through recently, and the slow rate of growth being recorded now. A rise in bond yields would signal some move towards normality. It could follow from the end of Quantitative easing and from some economic recovery.
 
For the time being investors are keener on riskier assets. The authorities around the world are trying to issue more liquidity into the system. The US recovery is strengthening. The Euro’s troubles have been temporarily curbed by the generosity of the European Central Bank to the EU commercial banks.  There may be buyers of long dated UK government bonds out there, but history suggests you do not usually get rich by lending to western governments at 2% or 3%.  It is certainly a good idea for the government to borrow as much as it can for as long as it can while rates are low, given its continuing need for hefty borrowings.

Investment is a stop start business these days. Western markets have a good few months, then plunge on talk of crisis. You can get a whole year like 2010 when returns are modest but positive, only to be followed by a year like 2011 when many managers lost money with share markets going down again.

We have long held the view that returns from western economies are going to be disappointing for several years. The only way round is if you are brilliant at spotting the short sharp rallies and getting out for the rest of the time. No-one can guarantee to do that. There are several reasons why returns could be lower than in the last century. The west is still heavily over borrowed, and has to cut its debts. Adding leverage adds to profits and earnings. Cutting leverage subtracts from profits, and cuts demand which in turns damages growth. The west now faces formidable competitors in the East, taking margin and orders away from large western multinationals. The very success of the West’s internet technology will transform or destroy many business models. As more retail goes electronic, as estate agents, head hunters, travel agents and the like switch to an online offer, so fees and charges come down. Customers can scour the worldwide web to find the best product at the lowest prices more easily than before the microchip wizards arrived.

It is true the arrival of more successful large competitors in the emerging markets also present some opportunities. For the best western companies it expands their markets and offers them new areas for growth. It is true the new technology spawns a whole new range of businesses doing things we did not dream about ten years ago. We just do not think this will be a sufficient offset for the problems caused by broken banks, over borrowed sovereigns, heavily indebted private sectors, or aggressive new competition. We are planning on lower growth rates and lower rates of profit and dividend growth in the west than before.

In such a climate the costs of investing matter more and more. If overall returns in the better years were 8% per annum, and costs were 2% per annum, the fund still enjoyed a total return of 33.8% over five years and 79.1% over ten years. If overall returns now may only average 6% and costs are still at 2% the total returns fall to 21.7% over five years and 48.0% over ten. 2% costs on a six percent return reduces the return by 31 percentage points over the ten years. If returns only manage 5% and costs are 2%, costs take more than a third off the ten year return dropping it from 62.8% to 34.4%.

That is why we have worked on producing a lower cost solution to investing. We concentrate on the Big Picture decisions over asset allocation which make the most difference to performance, whilst using index trackers in carry out the strategy. We look for well run indexed funds that get close to perfect tracking after all costs. That way we can cut costs substantially compared to a mixed fund with high-cost hedge funds, private equity and the like in the mix and with conventional manager fees on quoted portfolios. We also aim to keep transaction costs down, as these too subtract from your returns.

We advise Trustees to have a look at the impact fees and charges are having on their returns in an era of low returns generally. The fees and charges are more damaging when overall returns are poor. Some expensive funds are worth paying for, but they need to prove their performance and sustain it. Trustees need to be confident they can do that. We would be happy to help Trustees review their fees and charges and see if we can help manage the costs which do have such a big impact on returns.

Today’s news that the Greek debt reduction has attracted the support of 85.8% of the bondholders has been well received in markets. The Greek state can now use the collective action clause to make all bonds held under Greek law convert to the new terms. The Greek government will come close to hitting the IMF/EU targets for debt reduction through debt restructuring. Bondholders are being made to pay some of the bill of Greek excess spending in recent years.

Each bondholder will receive 15% of their money back in a cash equivalent, and 31.5% of the face value of their bonds in the form of a new 30 year Greek bond paying just 2% at the outset, rising to 4.3% over its lifetime if all goes well. The stated reduction in bondholder wealth is therefore 53.5%. However, the new bonds are unlikely to be worth their par value. Early indications are that Greek debt will continue to change hands on very high yields, meaning if a bondholder wants to sell their new bonds they will have another large loss. They might lose three quarters of the par value on the new bonds, taking their full loss to around three quarters of the capital value at the issue price of their original bond.

Individual investors of course may have lost a lot less, as they may have bought in at much lower prices, and will have received some income. The government is also offering sweeteners in the form of the promise of extra payments if the Greek economy grows well in the years ahead. These probably have little value today, though we all hope for the sake of Greece they do in due course become more valuable.

Whilst the markets are treating this outcome with relief, it is scarcely good news. An advanced country and a member of the Eurozone has failed to repay its debts. Markets still do not trust fully the new debt instruments the Greek state is issuing. The Greek economy, deep in recession, has just lost more potential spending power from private sector holders of these bonds. This follows hard on the heels of the extraordinary decision to cut the minimum wage by 22%, the minimum wage for young people by 32%, and some of the pensions in payment by 12%.

Greece is an extreme example of how a western economy locked into a single currency has to slash living standards to try to live within its means. After years of building up debt, the country faces the reality that no-one wants to lend to it on anything like normal terms. Some other western countries are facing the need to rein in their debts and to adjust to their lack of competitiveness against the emerging market economies and Germany. Those not in the Euro have been able to devalue, cutting living standards by the back door and altering the relative prices of imports and exports in a way which helps the local economy to adjust. Inside the Euro all the adjustment has to take place by some combination of smarter working, job losses, wage cuts, and in extreme cases failing to repay debts.

The Greek debt swap is seen as a success, but it is part of a much larger painful adjustment which is far from over. Portugal should be worrying, as they are still a long way from being able to return to the markets to finance themselves in the normal way.