Monthly Investment Strategy Update - June 2010
- Fiscal retrenchment will not be limited strictly to peripheral Europe...
Financial markets are in the process of getting to grips with the implications of the fiscal crisis that has followed in the wake of the 2008/09 banking crisis. The problems are not confined to the periphery of Europe, but are spread fairly widely through advanced economies, with some 60% by economic weight having concerning debt-to-GDP ratios. So it is not just in Europe that major fiscal adjustment is required over the coming years, but also in the US, Japan and the UK.
- …but the cuts will be felt there the most keenly, driving vulnerable economies into a double dip.
The European fiscal bail-out package announced in early May provides sufficient liquidity to buy time. But it does not resolve the underlying issue of lack of solvency, meaning periphery economies will need to accelerate fiscal consolidation in order to regain the confidence of markets. Such action is likely to drive these economies into recession. When combined with the export impact on the core economies, which will also undergo some fiscal retrenchment of their own, we believe euro-zone growth overall is likely to stagnate over the next couple of years. Indeed, the economic pain that fiscal adjustments will inflict on peripheral economies is so severe as to make debt restructuring, devaluation and the printing of money by the European Central Bank tempting policy options. At an investment level, this bodes badly for the euro but well for gold and German exporters on a relative basis. Equity markets will remain under pressure until the solvency issue is addressed.
- The UK will bear the brunt of weaker European imports.
Weak European demand will hit the UK harder than the US or Asia, given that the UK sends just over half of its exports to Europe. This comes at a time when the UK is poised to experience its own sharp fiscal tightening under a new coalition government keen to get ahead of the bond market and to avoid a sovereign debt downgrade.
- Trade and severe forced fiscal tightening are less of an issue in the US than further banking sector stress.
In the US, the threat comes less from trade impacts and more from the potential for further banking sector stress or the danger that the fiscal crisis results in a severe forced fiscal tightening. However, the dollar’s standing as a reserve currency and the bond market’s safehaven status mean the US is less likely to be forced into a sharp fiscal tightening than a small European economy. It is also not in the interests of China or Japan, which hold over 40% of US debt, to force a sell-off. The banking system, though, is of more concern. While the US banking system has very little exposure to the governments, consumers and businesses of the euro-zone periphery – unlike the German, French and UK systems – the banking crisis of 2008/09 is an object lesson in the interdependence of the financial system and how problems can spread. The moderate pick-up in Libor recently is a symptom of this issue.
- Markets may not yet have bottomed, but longer-term investors may soon find equity valuations attractive.
Equity markets are still in the process of pricing in a more realistic growth outlook for Europe and the risk that the fiscal crisis spreads and materially suppresses the global recovery. This means that it is probably too early to start buying risk assets. However, at times like these it is important for longer-term investors to use valuation as an anchor. At 12.3, the forward PE of world equities is below its historic average of 16.6 and getting close to the 10.4 seen when the market bottomed in March 2009. Since 1973, an investor buying UK equities on their current PE has on average made a one-year return of 13%. Of course, no return is guaranteed, investors buying UK equities at their current multiple have lost money13% of the time.
Disclaimer
Issued by Coutts & Co, which is authorised and regulated by the Financial Services Authority.
The value of investments, and the income from them, can go down as well as up, and you may not recover the amount of your original investment. Past performance should not be taken as a guide to future performance. Where an investment involves exposure to a foreign currency, changes in rates of exchange may cause the value of the investment, and the income from it, to go up or down.
The information in this document is not intended as an offer or solicitation to buy or sell securities or any other investment or banking product, nor does it constitute a personal recommendation. The information shown is believed to be correct but cannot be guaranteed. Any opinion or forecast constitutes our judgement as at the date of issue and is subject to change without notice. Any Coutts company, or a connected company, its clients and officers may have a position or engage in transactions in any of the securities mentioned.
The analysis in this document has been procured, and may have been acted upon, by Coutts & Co and connected companies for their own purposes, and the results are being made available to you on this understanding. To the extent permitted by law ad without being inconsistent with any applicable regulation, neither Coutts & Co nor any connected company accepts responsibility for any direct or indirect or consequential loss suffered by you or any other person as a result of your acting, or deciding not to act, in reliance upon such analysis.
Not all products and services offered by the individual Coutts companies are available in all jurisdictions, and some products and services may be available only through particular Coutts companies.
None of the overseas Coutts companies or offices is an Authorised Person subject to the rules and regulations made under the Financial Services and Markets Act 2000 for the protection of investors and depositors, and compensation under the Financial Services Compensation Scheme will not be available in respect of business transacted with them.
