January market overview

Early in the month President Obama may have received a political bloody nose from the good people of Massachusetts and will no doubt have to put his healthcare reform bill on hold, but he has bounced back with a populist stance in taking on the bankers. A re-imposition of previously restrictive legislation¹ will be very unpopular with Wall Street and therefore very well received by the rest of the population. It will, in all likelihood, spill over to Europe as well. Curbing bankers’ bonuses (amongst other measures) will probably do very little to sort out the fundamental issues of over-indebtedness of the West. Politicians have however shown in the past that they are sometimes hard pressed to think beyond the next election, not to speak about the next popularity poll. Northern Rock, RBS and Lehmans did not go belly up because of their trading activities – they bit the dust over-leveraging their balance sheet by lending to poor creditors and whether this was done by plain vanilla lending or the retention of securitised products is irrelevant. Nevertheless, separation of trading activities from banking now seems likely as few Republican politicians may want to imperil their careers by standing up for the banks – and the banks only have themselves to blame. It also seems likely that capital ratios will have to take account of an increasing range of off-balance sheet assets and this (more sensible) measure will have implications well beyond the European banks at which it is primarily aimed. All financial institutions will be under pressure to retain capital (lower dividends and rights issues) and shrink balance sheets to 'risky' borrowers (less lending and more sovereign bonds). Banking profitability is likely to be on a secular decline and this will have negative implications for global growth.

Deutsche Bank published the graph below which compares the profitability of the US financial sector with non financial sectors (rebased at 100 in 1970), and a clear anomaly exists:

¹ The United Sates Banking Act of 1933 was a law that established the Federal Deposit Insurance Corporation (FDIC) in the United States and introduced banking reforms, some of which were designed to control speculation. It is most commonly known as the Glass–Steagall Act, after its legislative sponsors, Carter Glass and Henry B. Steagall.

Source: RMB Asset Management / Bloomberg / Lipper Hindsight. February 2010.

They further stated that with hindsight it is clear that had financial profits not rebounded in the manner they have done over the last 12 months then the global economy would still be mired in a deep recession with the risk of Depression high. The footprints of the financial sector are all over the Global economy and to leave financial earnings back down at trend levels would be to leave a trail of destruction in the real economy. So whether it was luck or judgement, allowing financial institutions to return to super-normal profits again allows the economy to resemble 2007 in many ways.

Global equities pulled back during January with all the major indices in negative territory. In the US the S&P 500 retreated -3.6% in US Dollars, with their British neighbours across the Atlantic seeing a similar pull back of -3.6% (in Pound Sterling) in the FTSE All Share index. In Europe (-3.4% in euros) the theme was much the same, with US Dollar strength further detracting from returns for investors who favour the greenback as base currency for their global investments. Japan was the notable exception as the Topix lost only -0.7% in January, and ended in the black (+2.0%) when measured in US Dollar terms. Emerging equity markets faired slightly worse when compared to their developed counterparts as the MSCI Emerging Market Index produced a return of -5.6% in US Dollars. Most market commentators support the growth story for emerging markets, but this may just be somewhat of a contrarian indicator over the short term.

Global bond markets were stronger towards the end of month as investors’ enthusiasm for risky assets waned and demand for government bonds pushed yields lower. US Treasuries gained (JP Morgan GBI +1.6%) and in Europe (+0.4%) and the UK (+0.6%) government paper performance was also positive in local currency terms in spite of all the sovereign risk concerns. Investment grade bond spreads over government bonds widened, but the reduction in the underlying reference yield cushioned the effect. In the US, Eurozone and the UK investment grade bonds had a good month, and further out in the risk spectrum high yield bonds did particularly well (+1.3% in the US and +3.4% in the Eurozone), especially when compared to the weak equity markets.

The US Dollar strengthened against the two major European currencies (+3.1% against the euro and +0.8% against the Pound Sterling) as well as a number of emerging market currencies, but lost ground against the Japanese Yen (-2.7%). Commodity markets were also particularly weak as broad commodities, agriculture, oil and gold pulled back on fears of a less than robust global economic recovery.

Property securities continued to exhibit volatile performance and lost ground across all major geographical regions, save Europe. Our preferred exposure to this asset class is investment into direct property with managers who do not have any legacy issues or impaired assets in their portfolios, as this should provide much more of a diversification benefit than securities which have been closely correlated with equity markets in the recent past.

Source: RMB Asset Management / Bloomberg. February 2009

Source: Lipper Hindsight, February 2010

FOCUS – Some PIGS are more equal than others

In George Orwell’s cutting allegory Animal Farm, it is asserted by the pigs that "All animals are equal but some animals are more equal than others". This is an apt reflection of the present issues facing Greece, the least equal of the ‘PIGS’, as the rogues gallery Portugal, Ireland, (Italy) Greece and Spain have become known.

The credit crunch stemmed from a crisis of confidence relating to private sector debt that billowed into a significant systemic risk that had the financial system and even countries such as Iceland on the brink of collapse. Following on from coordinated multi-governmental initiatives the world gradually moved away from the risk of systemic failure that was a genuine concern following the collapse of Lehman Brothers in 2008. In the meantime, corporate and personal balance sheets have been stabilised if not repaired and much of the leverage has been transferred to the public purse through initiatives such as Troubled Asset Relief and Quantitative Easing. The markets’ attention has been gripped of late by solvency issues of a different sort. As government balance sheets bloat there is a degree of concern relating to their ability to finance their repayment obligations. The predominant risks associated with government debt relate to the ability and willingness of these countries to repay their debt holders in full, when required. Generally speaking neither of these risks is especially significant in developed markets as the majority of countries had scope to roll debt even if unable to pay it down and investor-friendly governments would baulk at the thought of defaulting on their debt. The cost of insuring against default of a sovereign issuer can be implied from the cost of a credit default swap contract on that government’s debt. As can be seen in Figure 1 below, the cost of insuring against default in many Eurozone countries was low in the years prior to the credit crunch and also there was a large degree of similarity in the CDS cost.

Today these spreads are significantly higher and reflect a greater apprehension of the potential risk of default from these issuers. Greece’s CDS is notably higher than other ‘second tier’ Eurozone countries that have come to constitute the PIGS. This is because Greece is in a particular mess and the proximity of potential default on that debt is greater than the other jurisdictions listed. Each of the PIGS have in their own way introduced emergency measures designed to convince investors that they are serious about reducing their borrowing, but Greece appears most vulnerable at present.

Greece has submitted a three year stability plan which is aimed at cutting the budget deficit from 12.7% to 2.8% of GDP. Furthermore, the government is likely to introduce something of a tax amnesty to encourage investors with funds abroad to repatriate them without fear of charges of tax evasion. That is not to say that taxation is likely to become lax. There have been protests in Athens from public sector trade unionists objecting to government moves to target them with higher tax. This move on the part of the Greek public is perhaps understandable, but also worrying in the sense that the majority of the proposals have thus far only rhetorical significance. Greece, a country with recent history marred by violent civil disorder, should be braced for a significant public backlash if and when these initiatives start to bite. Greece will ultimately have to restore its fiscal condition by creating a fiscal surplus which will provide funding necessary to bring down debt levels over time.

The Greek nation has, like the much maligned developed world consumer, been living beyond its means and has amassed a significant debt burden as a result. A succession of budget deficits has brought their debt level to over 100% of GDP. Having a high level of debt to GDP, although worrisome, is not necessarily catastrophic in its own right. With the right maturity profile and a willing market, outstanding debt can be rolled and hopefully managed down through time. Japan, for instance has 280% of GDP outstanding in debt and although the long term prospects of an ageing and miserly economy are poor, there is no immediately apparent risk of default there. This is partly due to the fact that governments with a free floating currency are able as a last resort to print money to meet their repayment obligations. The inability to monetise debt is a risk more usually associated with foreign currency denominated issues as the government of a particular country cannot print a currency of a different country. From an investor perspective, therefore, this Greek debt is tantamount to a foreign currency issue and so relies on whether foreign currency reserves or the ability to attain foreign currency sufficient to repay it.

Fig. 2 shows the yield convergence that brought European interest rates broadly into line prior to the issuance of the single currency. The converged rates reflected a united, if not formalised fiscal and monetary proposition from the member states that resulted in broadly similar levels of risk priced in on same-currency debt, hence the very similar spreads.The convergence trade now appears to be over and rather, the dominant theme is one of divergence. Given the lack of an explicit guarantee for ailing nation’s debt within the Eurozone, a degree of divergence between their interest rates is arguably appropriate, despite the same underlying currency and interest rate policy. Perhaps convergence was asking too much of such disparate economies, despite their shared currency and interest rates. In contrast, the US is an example of a functioning monetary union. Each state is effectively an economy in its own right and the performance of the USA perhaps suggests that only where there is true confluence of aspirations and culture as well as Federal fiscal and monetary policy makes currency union workable. Even in the US, however, there remains significant disparity of wealth throughout the population.

As Viewpoint comes to print, it appears that Europe is opening up to the possibility of aiding Greece in some capacity. The question that the Eurozone inevitably faces, however, is whether to use this opportunity to enact a greater synchronisation of economic policy across the 27 member bloc. There is no question that Europe is comprised of disparate economies and by managing only one element of their financial and fiscal proposition centrally, there remains scope for a vast array of different policies in terms of taxation and debt for each of the member states. Europe imposes many rules to encourage fiscal discipline on the part of its members, but there is a growing clamour to increase the formability of these structures. The ultimate step would be a fully integrated fiscal union, but that would be a significant departure from the present set up and is unlikely to occur in a single move. What is likely is an increased invasiveness on the part of Europe’s regulators which should pre-empt these destabilising events.

There is an argument that any bailout of Greece would perpetuate moral hazards similar to being ‘too big to fail’ in the banking world, however, the aim for stability seems laudable in this instance. A rescue package would bring relief to the Eurozone in the short term, but it might also be a source of considerable discord. The European Union is not obliged to bail Greece out and in doing so they will likely lose credibility in countries such as Ireland where a set of austere measures have been greeted by acquiescence by the Irish public. A significant capital injection to Greece would surely therefore be greeted with distain in Dublin if one of the PIGS were more equal than others. A different option for the Greeks would be to leave the single currency. This would provide the opportunity for Greece to manage their own interest rates in future, which is arguably appropriate given recent events. This move might even be positive for the Eurozone as a whole, although it will likely be destabilising in the short term. The effects for Greece’s debt would be severe, however and whatever currency the Greeks adopt would be likely to devalue significantly. Exit from the euro is politically very difficult and highly unlikely in this instance, however many second rate European nations may be quietly questioning whether ceding their independent interest rate policy was worth the risks. The PIGS generally do not seem economically congruent to Germany and other first tier European states and anything short of a full economic union will create the potential for mismatched interest and fiscal policy throughout the Union.

Greece clearly has troubled times ahead, the outcome of which may depend more on the actions of external forces than choices made by the Greek government itself. The Union will surely only assist Greece in a manner suggests an even playing field for all PIGS. The Greek executive may, therefore, only grudgingly accept assistance from the EU as this may require an impingement on Greece’s fiscal independence. Orwell’s character Squealer, himself a pig, sums up the quandary well: "Do not imagine, comrades, that leadership is a pleasure.   On the contrary, it is a deep and heavy responsibility.  [The leader] would be only too happy to let you make your decisions for yourselves.  But sometimes you might make the wrong decisions, comrades, and then where should we be?" 

Source: RMB Asset Management / Bloomberg. February 2009

RECENT MANAGER MEETINGS

INDUSTRY NEWS

ARTEMIS INVESTMENT MANAGEMENT

Sam Mettrick, Head of Strategic Alliances
Mettrick has moved to Artemis Investment Management as Head of Strategic Alliances based in London. He was formerly Head of Strategic Alliances at Henderson New Star.

CARMIGNAC GESTION

Charles Zerah, Emerging Markets Fixed Income Fund Manager
Zerah has moved to Carmignac Gestion as a Fixed Income Manager, and will be responsible for the Global Bonds. He was formerly Emerging Markets Fixed Income Fund Manager at Credit Agricole Asset Management.

FIDELITY INVESTMENTS

Arne Lindman, President and Chief Executive: Asia Pacific
Lindman has moved to Fidelity International as President and Chief Executive of Asia Pacific. He will report to Barry Bateman, Vice Chairman. Lindman was formerly Chief Executive at Prudential Corporation Asia.

GOTHAER ASSET MANAGEMENT

Herbert Schmitz, Chief Operating Officer
Schmitz will be retiring from Gothaer Asset management at the end of February 2010.

HERMES INVESTMENT MANAGEMENT

Fred Cleary, Rates Fund Manager
Cleary has moved to Hermes Fund Managers as a Director of Government Bonds. He was formerly at UBS, where he helped build a trading and research operation for US inflation linked markets in London and New York.

Samir Patel, Emerging Markets Equity Fund Manager
Patel has moved to Hermes as Director for Emerging Markets. He reports to Paul Bisping and Kees Verbaas, Co-Head. Patel was formerly a Fund Manager at Polar Capita.

Godliman Press Digest, Investment Week, Financial News, Investment Adviser, Financial Times, Beeley. June 2009.

INSIGHT INVESTMENT

Adam Mossakowski, Credit Fund Manager
Mossakowski has moved to Insight Investment as a Credit Fund Manager. He will be focusing on UK portfolios and will report to Peter Bentley, Head of Credit. Mossakowski was formerly at F&C where he was responsible for a range of Institutional and Retail funds.

JANUS CAPITAL CORPORATION

Richard Weil, Chief Executive Officer
Weil has moved to Janus Capital as Chief Executive. He replaced Tim Armour, Interim CEO. Weil was formerly Chef Operating Officer at PIMCO.

LIONTRUST ASSET MANANGEMENT

Bernard Asher, Ex-Chairman
Asher has stepped down as Chairman. He will retiring from the fund management industry but will remain as Non-Executive Director of Liontrust.

MERCER HR CONSULTING

Gary Simmons, Client Manager and Principal
Simmons has moved to Mercer as Client Manager and Principal based in London. He will be responsible for a portfolio of major clients and for developing Mercers human capital and government sector business. He was formerly at PricewaterhousCoopers, where he was a Partner working on strategic human resource issues for client sand private sectors in the UK, Europe, North America and the Middle East.

MOORE CAPITAL MANAGEMENT

Jean Philippe Blochet, Senior Fund Manager
Blochet has moved to Moore Capital Management as a Senior Portfolio Manager. He was formerly a Founding Partner of Brevan Howard Asset Management.

OLD MUTUAL ASSET MANAGERS

Patrick O’Sullivan, Chairman
O’Sullivan has moved to Old Mutual Asset Managers as Chairman. He took up his new post on 1 January after Collins retired from the board on 31 December 2009. O’Sullivan is also Non-Executive Director of Man Group and Bank of Ireland. He has held Non-Executive Directorships at Collins Stewart and Zurich Financial Services.

ORIEL ASSET MANAGEMENT

David Urch, Chief Investment Officer
Urch has moved to Oriel Asset Management as Chief Investment Officer. Hew was formerly a UK Equity Fund Manager at Fidelity International.

RATHBONE UNIT TRUST MANAGEMENT

Mike Webb, Chief Executive Officer
Webb has moved to Rathbone Unit Trust Management as Chief Executive. He replaced Peter Pearson Lund, who is retiring. Webb was formerly Head of Business Development at Hermes Fund Managers. Before that he worked at Invesco Perpetual as Chief Executive Officer.

SCOTTISH WINDOWS INVESTMENT PARTNERSHIP

Mark Connolly, Head of Fixed Income
Connolly has moved to Scottish Widows Investment partnership as Director of Fixed Income. He was formerly a Director for Distribution and Client Services at Standard Life. Before that he worked at Deutsche Asset Management as Head of Institutional Business.

THREADNEEDLE INVESTMENTS

James Thorne, UK Equity Fund Manager