Investment Newsletter February 2016
Fear Factor Mike Deverell Investment Manager
The market turmoil we’ve been experiencing since last summer has recently moved into a new phase. As we’ve written previously, we believe the volatility has been caused by a few main factors all happening at the same time: •
Slowing growth in China and reduced commodity demand.
•
An oversupply of commodities, especially oil.
•
Divergent monetary policy with the US putting rates up and much of the rest of the world cutting rates. This has led to capital flows into the US from the rest of the world, pushing up the value of the dollar.
This all culminates with plunging commodity prices, notably oil. Remember that commodities are priced in dollars and so the strengthening dollar has helped push down oil prices and those of other commodities. Whilst this confluence of events is the main cause of the recent slide in stocks in our view, the longer this negativity persists the more chance there are of knock-on effects. Recently, we have seen that with the slide in bank shares.
Equilibrium Asset Management LLP (a limited liability partnership) is authorised and regulated by the Financial Conduct Authority. Equilibrium Asset Management is entered on the Financial Services Register under reference 452261. The FCA 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 February 2016
Bank Balance
As commodity prices slide it becomes harder for mining and energy stocks to make a profit. This not only hits their share prices but it also makes it more likely that such companies might default on debts. This has a knock-on impact on the banks which may have lent them money. As the market turmoil has gone on this has translated into a wider fear of a global recession. Banks are highly cyclical and do well when the economy is doing well. However, in a recession the chance of mass defaults on loans increases and so fears for the economy translate into fears over banks. Most banks also make money from trading through their investment arms and many even have asset management businesses. Some banks even participate in commodity trading. The falling stockmarkets will impact on those revenues.
difference between the rates for long term and short term borrowing have fallen. Banks make money from borrowing for the short term at low rates and lending over the long term at high rates, so as the difference between the two narrows they find it harder to make profits. There are multiple reasons why banks might find profits harder to come by, and therefore there are rational reasons why their share prices should fall. However, they have fallen more sharply than is perhaps justified by these factors.
Finally, as some central banks such as those in Europe and Japan move to negative interest rates, the
Sovereign Wealth Funds
Another impact of falling oil prices is that the major exporting countries are now feeling the pain in their own economies.
The chart below from Bloomberg shows the allocation that some of these funds have to various sectors of the stockmarket. The biggest sector by far is financials.
Many of these countries have built up large sovereign wealth funds over the years, investing their assets in a wide variety of ways. Oil rich Norway has the largest sovereign wealth fund in the world at more than $800bn, and the gulf states also have notably large funds.
Other people have started to worry about bank solvency. In particular, they worry about a new class of bond called a “contingentconvertible” or “co-co” bond.
Many of those countries are now starting to draw down on those funds to prop up their economies or currencies, which means selling investments.
These forced sellers are a big reason for share price falls in our view. Equilibrium Asset Management LLP (a limited liability partnership) is authorised and regulated by the Financial Conduct Authority. Equilibrium Asset Management is entered on the Financial Services Register under reference 452261. The FCA 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 February 2016
Co-cos pop?
After the financial crisis, new regulation required banks to hold more capital. Without going into too much detail, bank capital is divided into various tiers with tier one being the most important. Banks with higher tier one capital ratios have a bigger cushion against a downturn. This cushion comes partially from capital raised via equity and bonds. In the event of an insolvency, equity investors are normally wiped out first, then tier one debt (bond) holders, then tier two. Only at the very end would depositors potentially lose their cash.
risk. If a bank’s capital falls below a particular level then the bond is converted into equity (shares). In addition, unlike other levels of bonds the coupon or interest payments can also be suspended in certain circumstances, although if they do the bank is also unable to pay a dividend on their shares. Deutsche Bank has been particularly hard hit by such concerns and their co-co bonds have been downgraded by Standard & Poors to B, which is getting towards “junk territory”.
In order to increase tier one capital levels banks have issued co-cos. These bonds have higher yields than other classes of bank debt because they are higher
Another Financial Crisis?
How likely is it that a bank will default? The chart below from the FT shows the common tier one ratios of some of the major banks. These capital buffers are significantly higher than before the financial crisis. For example, Deutsche’s tier one capital is over 11%, essentially meaning they would need to write down more than 11% of their balance sheet before wiping out all tier one capital. Only after that do holder of tier two bonds potentially lose their investments, and it is a long way before depositors are at risk.
different beasts to what they were in the financial crisis. However, it is the hangover from the financial crisis that is why Deutsche has been specifically a cause for concern. The bank made a loss of 6.8bn Euros in 2015, after writing down 12bn Euros as a result of restructuring and litigation costs. For example, they had to pay 2.5bn US dollars to the US and UK regulators to settle Libor manipulation claims and have set aside 5.5bn Euros for future legal costs. Whilst the ongoing financial conditions may well hit bank profits, their safety is not a concern in our view.
In 2007 Deutsche Bank’s tier one ratio was little more than 8%. Other banks have increased their capital base even more significantly. Banks are therefore very
Equilibrium Asset Management LLP (a limited liability partnership) is authorised and regulated by the Financial Conduct Authority. Equilibrium Asset Management is entered on the Financial Services Register under reference 452261. The FCA 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 February 2016
Self Fulfilling Prophecy?
I started this newsletter by stating we thought market turbulence was a result of specific factors with a particular impact on the commodity sector. It is worth reminding ourselves that most of the world are commodity consumers and not commodity producers. Falling prices reduce costs for most companies and individuals. However, this is not always appreciated by the market. Take airlines, which are a big beneficiary of lower oil prices, since their fuel costs fall dramatically. Why should their shares have fallen along with the rest of the market? The answer is fear. The volatility has led to fears of a recession, which of course would mean less people go on holiday. We still think a global recession will likely be avoided and that most likely investors will soon start to differentiate between good and bad companies. Having said that, we acknowledge there is the danger of the world economy being talked into a downturn. The longer this market volatility continues, the more fear there is of a recession. This could cause individuals and companies to delay some spending or investment “just in case�. That in itself could reduce economic growth. Whilst we believe this is not currently the most likely scenario, we do acknowledge that dangers have increased and we will continue to be vigilant when managing your portfolios. However, in general we think there is some very good value beginning to emerge across a variety of sectors. Once sentiment turns, these investments could rebound very quickly.
Equilibrium Asset Management LLP (a limited liability partnership) is authorised and regulated by the Financial Conduct Authority. Equilibrium Asset Management is entered on the Financial Services Register under reference 452261. The FCA 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 February 2016
General Economic Overview Whilst markets have continued to be turbulent, the global economic picture remains fairly stable. The global economy continues to grow led by the US and the UK, even if those economies have slowed slightly. Weakness is mainly in those countries who produce and export commodities. Inflation remains low but will rebound somewhat as the year progresses as some of the previous commodity falls start to drop out of the annual equation. However, despite this we think it unlikely the Bank of England will put up rates this year and the US Federal Reserve will be much more cautious about their own rate hikes. Asset class key + positive - negative = neutral (normal behaviour)
+5 strongly positive -5 strongly negative
Asset Class
Score
Equity Markets Our score remains neutral as it was last month. Markets generally look good value at these levels and we believe we could see a strong rebound at some point. However, as risk remains we have adjusted our score accordingly. We are currently more focused on active funds and continue to prefer Japan and smaller companies in the UK.
=
Fixed Interest Our score has increased again from -3 two months ago to -1 this month. Whilst gilts have done very well recently and have extremely low yields, corporate bonds have moved in the opposite direction. This leaves the “spread� between the two looking more attractive than for several years.
-1
Commercial Property Our score has remained at -2 as it was last month. Commercial property returns are continuing to remain steady, if unspectacular. Property continues to provide attractive diversification to equities and bonds.
-2
Cash With interest rates remaining at record lows, returns on cash will remain below average for the foreseeable future.
-5
Balanced Asset Allocation For a typical balanced portfolio we are underweight fixed interest and slightly underweight property. We are slightly overweight equity and also have additional holdings in defined returns and alternative equity.
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, 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.
These represent Equilibrium’s collective views. The value of your investments can fall as well as rise and are not guaranteed. Investors may not get back the amount originally invested. 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. Equilibrium Asset Management LLP (a limited liability partnership) is authorised and regulated by the Financial Conduct Authority. Equilibrium Asset Management is entered on the Financial Services Register under reference 452261. The FCA 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.