Investment Newsletter July 2012
The Fiscal Cliff-Hanger Whilst events in Europe rumble on, the health of the US economy is arguably even more important to world growth. In the early part of 2012 the US economy exceeded many peoples expectations, however in the past couple of months the picture has stagnated somewhat. Investors are now starting to become concerned about the effect of future tax increases and spending cuts due to come into place at the start of 2013. This has become known as the “fiscal cliff”.
What is the fiscal cliff? Until now the US has not gone down the same “austerity” path that has become the norm in Europe. They have instead attempted to stimulate their economy, deferring attempts to reduce their budget deficit until the economy is (or is supposed to be) growing more robustly. However, “mañana” has to arrive eventually and at 1 January 2013 a number of previously agreed measures come into play: • Tax cuts originally implemented during Bush’s reign and extended by Obama’s administration, are due to be reversed. • A temporary cut in “payroll tax” is to come to an end, increasing tax by 2% for workers. • New taxes relating to “Obama-care” come into force. • Emergency unemployment benefits expire. • A raft of spending cuts come into force. According to analysis from JP Morgan, around $550bn will be taken out of the economy by these changes, amounting to between 3.5% and 4% of GDP. For an economy which is currently growing by only around 1.9% pa as at the end of the last quarter, this could potentially plunge the world’s largest economy into a deep recession. With Europe unlikely to be strongly recovering by the year end and even emerging market growth slowing, this would likely see the world economy as a whole return to recession. Equilibrium Asset Management LLP (a limited liability partnership) is authorised and regulated by the Financial Services Authority. Equilibrium Asset Management is entered on the FSA register under reference 452261. The FSA regulates advice which we provide on investment and insurance business; however it does not regulate advice which we provide purely in respect of taxation matters. Copyright Equilibrium Asset Management LLP. Not to be reproduced without permission
Investment Newsletter | July 2012
Lemmings So will the US economy fall off a cliff and will the rest of the world, like lemmings, follow? The consensus view is that either the tax increases or spending cuts (or both) will be watered down or phased over a longer period, and so the effect is unlikely to be as dramatic as feared. However, this picture is complicated by the presidential election this year. With the Democrats currently having a small majority in the Senate and the Republicans having a marginally higher share of seats in Congress, this seems like an issue which will not be easily resolved. We saw last year, when the US debt ceiling needed to be increased, that Republicans would not agree unless the Democrats gave in to some of their demands. We would expect to see negotiations go to the wire and a decision made only at the last minute. Ultimately, it is in the interest of no-one for the US economy to re-enter recession, and so we would expect the fiscal cliff to be more like a gentle slope. However, debts have to be repaid some time, and this will be a drag on world growth for some years to come.
Political Risk Once again we have an example of politicians and governments having more and more effect on economies and markets. “Political risk”, something we used to associate with emerging market investing, is now more and more prevalent in all asset classes and regions. Writing in the Financial Times about the US debt issue, David Cote, CEO of Honeywell says: “Chief executives hate going to Washington. No one person can say yes, everyone can say no, and it takes 100 people to get anything done.” This sort of political gridlock is also what we’re seeing in Europe and is why the sovereign issues on this side of the Atlantic continue to rumble on. However, nothing kicks a politician into action like an upcoming election. Mr Cote is backing a campaign to make the US debt issue a major part of the presidential campaign. He wants to see a full televised debate devoted to the subject, and a long term deficit reduction plan put in place. At present, governments around the world remain too focused on short term sticking plasters, rather than fixing their problems. Until they start to take a longer term view, we are likely to see markets remain volatile.
Mike Deverell
Investment Manager Equilibrium Asset Management LLP Brooke Court Lower Meadow Road Handforth Dean Wilmslow Cheshire SK9 3ND United Kingdom Visit us at www.eqasset.co.uk t : +44 (0)161 486 2250 f : +44 (0)161 488 4598 e : askus@eqasset.co.uk Equilibrium Asset Management LLP (a limited liability partnership) is authorised and regulated by the Financial Services Authority. Equilibrium Asset Management is entered on the FSA register under reference 452261. The FSA regulates advice which we provide on investment and insurance business; however it does not regulate advice which we provide purely in respect of taxation matters. Copyright Equilibrium Asset Management LLP. Not to be reproduced without permission
Market Views | July 2012
General Economic Overview European debt issues have abated somewhat but have not gone away, and we expect these to continue to weigh on markets for some time. Global economic growth is muted with UK in recession, and Europe likely to be in recession when the next figures are announced. Central banks are trying to stimulate economies via interest rate cuts in China and Europe, and more quantitative easing in the UK. Inflation is falling back globally, however all this stimulus could eventually lead to this rising significantly.
Asset class key + positive - negative = neutral (normal behaviour)
+5 -5
strongly positive strongly negative
Equity Markets We remain very positive based on valuations such as the Price/Earnings ratio. European debt fears may cause short term volatility and markets could fall before they rise. However, at this level, equities look fantastic value in our opinion. We particularly favour the UK market.
Outlook
+5
Fixed Interest Interest rate risk has receded for the short term but inflation could hurt bonds in the long term. Corporate Bonds still provide decent yields and could do reasonably well in this environment. We are avoiding Gilts whose values have been inflated due to recent risk aversion.
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Commercial Property Whilst the rental yield on commercial property remains attractive at over 6%, this is diluted by high levels of cash in property funds. We can foresee some capital losses although we believe these will be small and that overall returns will probably be positive, but low.
-5
Residential Property
-5
We believe prices are likely to remain flat over 18 months. Cash With interest rates remaining at record lows, returns on cash could remain below average for some time. However, there is a short term safe haven appeal.
A neutral score (=) means we expect the asset class to move in line with our long term assumptions: 10% pa for equity, 7% for property, 6% for fixed interest, 5% for residential property, and 3% for cash. A +5 score means we think the asset class could outperform by 50% or more. A -5% means we think it could underperform by 50%. A negative score does not necessarily mean we think the asset class will fall. * Includes Defined Returns holdings. See previous briefings for details.
These represent Equilibrium’s collective views. There are no guarantees. We usually recommend holding at least some funds in all asset classes at all times and adjust weightings to reflect the above views. These are not personal recommendations so please do not take action without speaking to your adviser.
-5