UK: Investment Management Outlook - November 2011

Last Updated: 4 November 2011
Article by Smith & Williamson


Cautioning against excessive exuberance

Given the degree of concern surrounding the systemic risk posed by the Eurozone crisis (endangering both the global banking system and economy), the IMF meeting in Washington at the end of September assumed enormous importance in providing reassurance that the crisis would be confronted by a substantial policy response. The direct involvement of the US Treasury Secretary at this meeting added credence to the belief that the Eurozone leaders would finally produce a 'shock and awe' bail-out fund together with a cathartic and sizable bank recapitalization package. The post meeting market response was immediate, with risk assets including global equity markets bouncing 10% from their lows. The euro also strengthened. The rally in equities was further buoyed by evidence that the US economy was not just avoiding a double dip but was in fact registering a modest rebound and Q3 earnings reports were meeting expectations.

Initial excitement regarding the scale of the potential Eurozone bail-out package rapidly dissipated as it became evident that the European leadership structure appeared incapable of delivering a comprehensive and coordinated remedy. The fact that the market has reacted so positively to what has to be called a 'de minimis' rather than a 'grand' plan is testament to the sheer relief that an agreement has finally been reached. While this will buy the authorities some time we remain sceptical that this will provide a long term solution. The Eurozone remains extremely vulnerable to further pulses of tension as growth slows in 2012 and sovereign solvency risks increase correspondingly.

While risk assets – particularly equities, have experienced a very strong move we caution that as we close out 2011 and focus more on 2012 the outlook remains challenging. The 'New Normal' lower nominal growth trajectory continues to exert pressure on solvency arithmetic (particularly in the Eurozone) but also imposes significant operating leverage risk to earnings growth forecasts. Consequently, we would caution against excessive exuberance.


The rebound in the economy arrives at an opportune time

The rebound in US economy has arrived at a critical time as it has counterbalanced concerns over the Eurozone debt crisis. The main contributor to the recovery was the rebound in personal consumption expenditure albeit at the expense of savings. While there is understandable relief that the economy is displaying some resilience and has avoided a double dip this should not be confused with confidence that the economy is on the cusp of a robust recovery. The IMF forecast modest growth of 1.5% for the whole of 2011 and 1.8% in 2012 - about half the normal run rate. The core problem for the US economy remains that of high unemployment and persistent weakness in the housing market. With productivity levels falling and unit labour costs rising it seems unlikely that US corporations are about to embark on a massive hiring spree.


A proactive MPC

Despite witnessing an energy led surge in CPI and RPI to 5.2% and 5.6% respectively, the MPC voted unanimously to kick start a second round of Quantitative Easing (QE) in October. The MPC justified the injection of additional liquidity into the system by referring to the underlying weakness of the UK economy and the vulnerability of the banking system to potential Eurozone bond defaults and bail-outs.

The parlous state of the UK economy was emphasized by revisions to historical GDP data by the Office for National Statistics which showed that the decline in output in 2008/9 amounted to –7.1% compared with the original estimate of -6.4% and was the deepest contraction in UK output since the –7.6% decline in the 1930s. Three and a half years after the recession the UK economy is still 4% below prior peak levels a profile that has not been seen post war. With a weak labour market (unemployment has nudged above 8%) real disposable income is likely to remain negative for several more months and supports Mervyn King's view that inflationary expectations are not rising and domestically generated inflation is 'almost zero'. Although at some stage in 2012 disposable income will be boosted by declines in inflation, the MPC are highly likely to expand the scale of QE in 2012 to address the weakness in underlying demand.

The equity market has rallied sharply from the early October lows and has been buoyed by optimism that forthcoming meetings will resolve the Eurozone crisis and that QE benefits risk assets. Corporate cash flow remains strong and is producing improved dividend payouts. The key concern remains that Eurozone bail-out proposals will not eliminate concerns over the viability of the euro and therefore trigger another 'risk off ' move.


Still not in front of the curve

After hosting a sequence of preparatory meetings the Eurozone leaders held their 14th crisis summit in 21 months on 26th October to attempt to lay out a 'Grand Plan' to resolve the euro crisis. Unfortunately, rather than seizing the opportunity to display a well choreographed initiative, the Eurozone leaders have spent the last few weeks haggling over detail and appearing out of step. After lengthy and strained negotiations the summit eventually agreed plans for a 50% haircut on Greek debt, a €106bn bank recapitalization and the expansion of the EFSF to c. €1tn by the end of November. While the terms of the plan were very much at the low end of expectations, the markets have expressed enormous relief that at last, agreement has been reached. Throughout the negotiations Germany has driven a hard bargain and has succeeded in capping their guarantees to the EFSF and sought the commitment that the ECB will stop the purchases of bonds once the enlarged EFSF is in place. While the authorities are keen to avoid the Greek haircut triggering Credit Default Swaps (CDS) they must be careful that this manoeuvre does not have the undesirable effect of driving other peripheral bond yields higher.

Stepping back from the noise it is evident that the Eurozone still faces structural headwinds. The first is the absence of functional leadership structures with domestic political imperatives constantly overriding economic necessity. The seismic shift in the political power base of the Eurozone towards a dominant/assertive Germany has created a rift in Franco- German relations. The fact that there is no indication the Germans will accede to fiscal union fundamentally undermines the currency union. Finally, the lack of growth continues to exert enormous strain on solvency arithmetic and exacerbate the massive differentials in competitiveness. Eurozone leaders have once again missed the opportunity to get in front of the curve.



While Chinese growth is starting to slow and has been impacted by the combination of the weakness in developed economies and the delayed impact of tighter domestic policy, the economy still looks capable of delivering somewhere between 8.5-9% growth this year and next. By Chinese standards this constitutes a soft landing. The government is endeavouring to reorientate the economy away from export to consumption led growth. If the economy was to show signs of decelerating too fast then fiscal stimulus will be deployed – unlike 2009 it will focus on tax cuts (boosting demand) rather than infrastructure projects.

While CPI inflation is proving stickier than expected and remains above 6% the decline in M2 money supply growth and the recent fall in commodity prices indicate that inflation should start declining soon.


The Japanese economy has started to recover from the impact of the earthquake and tsunami. The supply chain disruptions were not as great as first feared and consensus forecasts expect the rebuilding process to deliver 2.8% growth in 2012. The yen has rallied significantly partly in response to capital repatriation but also due to its safe haven status. The pressure this is exerting on the economy and corporate margins has prompted the finance minister together with the BOJ to consider measures to curtail the recent strength of the currency.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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