As we come to the end of the first quarter, it is worth reflecting on what has happened in world stock markets. Generally equities are higher, despite a sharp correction between mid January and mid February. Asian markets have been mixed but North American equity markets, by contrast, have shown considerable strength.
The great surprise has been the Japanese equity market, which has done well both in absolute terms and in currency adjusted terms. The impact of currency movements has been considerable. Both the pound and the euro have fallen sharply against the US dollar.
In effect, the UK has seen a major devaluation from its 2008 peak and that process of depreciation continued in the first quarter of this year. As a result of this devaluation, UK industry and business has become more internationally competitive. Markets, of course, have worried about the size of the UK government’s deficit and the outcome of the general election likely in May this year.
The euro, meanwhile, has been overshadowed by the problems of Greece and the fear that these problems are both more fundamental and likely to have a more widespread impact elsewhere in Europe too. So far these problems have been contained and Europe, as a whole, has benefitted from a modest rerating of the euro. It is an open question as to how much further this has to run.
Throughout the period, we have remained as fully invested as possible in equities, taking the view that equity markets remain in a primary bull trend. We have taken this view since early May 2009, and had been building up towards that position over the six months prior to that.
Over the quarter, there have been some significant shifts in our asset allocation between equity markets. For a fully invested equity portfolio, we have ratcheted up our exposure to North American equities further – such that at the end of March, our total exposure in this area is around 46% of net assets compared with a 34% exposure at the end of last year.
Our Japanese exposure has also risen to around 7% of net assets, for a fully invested portfolio, compared with 2% at the end of December. This has been possible as a result of a relatively low exposure to Continental European equities (around 5% at the end of March) and by squeezing our exposure modestly in Asia ex-Japan. The latter accounted for 14% of net assets at the end of March, compared with 17% at the end of December.
We have avoided bonds, partly because our risk budgets have been fully absorbed holding equities and partly because we remain concerned about the deterioration in government finances in various parts of the world. Our sense is that government bonds are in a low grade bear market. Thus far the selling pressure has mainly been felt in the peripheral euro area bond markets.
The UK budget last week provided a snapshot of the UK’s fiscal position. The UK Chancellor’s budget judgement was relatively conservative. The UK Chancellor revised lower his forecast for the UK fiscal deficit from this fiscal year and the subsequent five years by an average of £9.2 billion a year with the biggest downward revisions in the first two years. In essence, the UK government locked in the gains from the recent better-than-expected deficit prints.
Where previously the UK government had been looking to halve the deficit in four years, it now expects to more than halve the deficit over that period. As a result, the UK government expects to restrict the debt incurred by the end of 2014-15 by a further £75 billion or to 75% of GDP. This decision to save the benefits from improved economic performance contrasts with the Pre-Budget Report where the Chancellor ‘spent’ most of the benefit from positive revisions.
The UK government generally stuck to its GDP growth forecasts. Growth is still expected to be in the region of 1.0%-1.5% for this year which, as it happens, is broadly in line with market expectations but, for next year, the Chancellor nudged his forecast lower by 25bp to 3.0%-3.5%. On the revenue side, the Budget forecasts show a robust 6%-7% recovery in receipts each year from April this year.
The main news on the revenue side was the decision to phase in fuel duty in three stages from April to January instead of a bullet 3p increase in April. No doubt this gradualist approach reflected the imminent general election. There were no changes in VAT, income tax or capital gains tax rates. However, the higher income tax rates and national insurance rates announced in the Pre-Budget Report in December will go ahead as planned.
The UK government’s spending plans were kept deliberately value. However, there will be sharp spending cuts after the general election and there are indications that government departments are well advanced in preparing options for the incoming administration. Meanwhile, so called ‘efficiency savings’ have been stretched to the limit of credibility.
Within our North American equity portion, we have had substantial exposure to Canadian equities which has been helpful. Canada, of course, is a major beneficiary of strong resource prices. Rising commodity prices have helped its currency to rise steadily in recent years. Somewhat more effective regulation has helped Canadian banks to avoid the massive losses that caused havoc in the US and European financial sectors. The fiscal picture also is the best among the major developed countries and the Canadian economy’s performance compares favourably to that of most other developed countries.
The likely strength of the cyclical recovery in the US has been central to our view of the world for the last nine months and that view appears to be working out. The US now has a competitive currency, competitive labour costs, robust corporate balance sheets and economic data confirms that the country is on a solid recovery path. This has been and is likely to continue to be positive for equities.
The prospect for US dollar bonds is less obvious. As US economic and financial conditions continue to normalise, real yields should also normalise. Indeed, yields on US Treasuries have been rising – recently US Treasury bond auctions have been received tepidly and 10-year swap spreads have turned negative. In this sense, markets are making a return to the mean move.
In the event, the EU heads of government provided some sort of back up undertaking to Greece last week. There was no commitment to concessionary terms and a role was provided for the IMF which, frankly, is the only institution with the experience, people and processes in place to implement a package and then to enforce the fiscal discipline that will be necessary within a relatively concentrated three year timetable to close the Greek government’s fiscal deficit.
This will be painful, as the latest Irish GDP numbers issued last week demonstrate. We now know that Irish GDP fell by 2.3% quarter-on-quarter in the fourth quarter of 2009. This was far weaker than t he 1.0% quarter-on-quarter contraction expected. At the same time, the third quarter reading was also revised down to -0.1% quarter-on-quarter from a previously reported increase of 0.3% quarter-on-quarter. The contraction in the Irish economy has been led by declining investment (-9.7% quarter-on-quarter, after -10.3% quarter-on-quarter in the third quarter) – indeed, Irish investment has now fallen by a staggering 52% since the peak in the first quarter of 2007.
On the output side, that is reflected by ongoing weakness in industrial gross value added. Elsewhere on the expenditure side, private consumption in the fourth quarter fell by 0.3% quarter-on-quarter and government spending was down by 0.8% quarter-on-quarter. Net trade had little impact in the fourth quarter, with exports edging up by 0.1% quarter-on-quarter and imports falling by the same magnitude. As a result, the Irish economy has now contracted by 12.6% since its peak in the first quarter 2007 (and 18.7% in normal terms). Not surprisingly, asset values have taken the biggest hit. Household wealth has declined sharply.
All of this reinforces our view that European growth faces real headwinds in the months ahead as some deflationary forces are unleashed.