The year so far
In common with our recent quarterly reviews to investors, we
are, once again, having to report on a very eventful three months.
When we last wrote to you towards the end of April we were
concerned with the events unfolding in Europe and commented – ‘the
absence of a blue print describing how to support a member state
facing default, or how any of the burgeoning deficit will be
controlled, let alone repaid, serves to expose the lack of clear
leadership across Europe and has unsettled investors around the
world’. As you will be aware, bond markets became increasingly
concerned European policymakers were not addressing the funding
problems facing member states, particularly Greece nor, more
importantly, did there appear to be an appreciation of the
contamination risk any default could cause to financial markets
around the world. A run on European commercial banks, similar to
that witnessed post the collapse of Lehman Brothers in September
2008, was on the horizon and drastic action was required, and fast.
Crisis meetings over the weekend of 8 and 9 May resulted in a
‘shock and awe’ EU-led rescue package to remedy the immediate
issues faced and provide the necessary blue print we refer to
above. The funds to be made available as part of this plan totalled
€750bn, including financial assistance from the International
Monetary Fund (IMF).
It is important to reflect on these events as they created a
step-change in the mindset of investors and the subsequent
performance of risk assets through the remainder of the quarter. A
timely reminder was served to all market participants that the
economic crisis was far from over and this called into question the
confidence behind the global recovery, which had manifested itself
in rising financial asset values. The fiscal retrenchment being
demanded of member states by the EU and IMF, as the price for
receiving funds to refinance, would clearly result in rising taxes
and cuts in public spending. Reform of social contracts –
particularly relating to pension and healthcare benefits – were
introduced across Europe and even Germany, the major
creditor-nation within the EU, introduced plans to rein in its
budget deficit. Investors soon recognised these actions had created
powerful deflationary forces across the entire continent and, with
them, a danger Europe may slide back into recession.
As the next leg of the crisis played out in Europe, economic
newsflow from the US served to compound the uncertainties
surrounding the global recovery. Quarter one GDP was revised down
to 2.7% confirming the economy had not expanded at the rate
expected and other key indicators such as growth in employment and
house prices started to soften. It was reported real household
incomes had fallen and this increased the risk consumer confidence
and spending would retreat. North America and Western Europe,
together, account for 60% of global private consumption and through
the second half of the quarter markets started to price in the
dangers falling consumer demand could bring. Further afield,
evidence that the Chinese economy had slowed and wage inflation
increased, tempered investor confidence in the country and the
wider region. A spate of strikes in China suggests wages will rise
further and this has put pressure on the authorities to engineer a
slowdown in growth to counter the inflation threat. In the minds of
investors, a slowing China will lead to a slowing global economy
and asset prices through this reporting period have adjusted to
reflect this.
All in all, a difficult quarter, leading to sharp falls across
equity markets. Over the three months, ending June, the MSC World
Index ($) fell 13.3%, the FTSE 100 was down 13.4%, the S&P 500
($) 11.9% and the FTSE Europe – ex UK (£) fell 16.4%. Emerging
markets also lost ground with the MSCI Emerging Markets ($) falling
9.1%. Corporate bond markets fell over the quarter, as did global
listed property shares and most major commodities, with the
exception of gold.
In our last report we applied probabilities to what we thought
the future economic landscape would look like and concluded our
base case (55% probability) was for a ‘sub-par, two-speed recovery’
with a tepid economic performance delivered by the developed world
and a much more robust performance coming from Asia and developing
nations. We applied a 30% probability to our ‘hard times ahead’
scenario where a period of economic stagnation could prevail with
the burden of excessive fiscal deficits, escalating national
indebtedness and negative wage growth engulfing Western governments
and consumers alike and triggering a prolonged deflationary
spiral.
Based on this outlook, we sought to manage the risks associated
with these probabilities by continuing to adopt a ‘barbell’
approach to portfolio construction. We have allocated to assets
which we believed would rise in the event of ‘hard times ahead’
but, at the same time, we have built or maintained exposures to
assets and geographies which would deliver investment returns if
the sub-par, two speed recovery continued to be the outlook
discounted by markets.