Report on Q2 2016

Report on Q2 2016

6 Jul 2016

On the face of it, the quarter was dominated by the UK Brexit referendum decision on 24 June though, in the main, trends were consistent throughout the quarter. The FTSE 100, which delivers its rare moments of outperformance in times of nervousness, had continued to do better than the FTSE 250 up to 23 June. After the referendum result this trend was dramatically extended, partly fuelled by the sharp fall of sterling against the US dollar.

At the close of business on 30 June, the 100 was up by 4.9% in the quarter and the 250 was down by 4%, a huge difference in fortunes. (Despite this, over the last 5 years the 250 is +35% and the 100 just +8%).

If this signalled nervousness about the future viability of the UK there was no sign of that in the performance of gilts. 10 year gilts yielded c.1.50% three months ago. Now they pay just 0.80%. What this seems to tell us that a prolonged depression is more likely than either a renewal of inflation (normally a probable result of currency devaluation) or a default by the UK government (even though we don’t really have a government at present).

The message from elsewhere, especially the EU, is the same. 10 year bund yields were 0.14% three months ago. They are now, as predicted, negative (-0.17%). In Switzerland, even 30 year government bonds yield less than zero. This seems to be confusing aversion to risk with a disinclination to continue to remain alive. The future is unknown. Get over it.

I sold some shares ahead of the referendum result on the mistaken view that we would probably vote to Remain. I think that the EU economy is burdened by many problems – unreformed labour markets, burdensome state pension liabilities, unfavourable demographics and ailing banks. European politicians have been allowing the ECB to carry the burden with its “whatever it takes” monetary policy. As I wrote before, “QE looks desperate and desperation does not promote confidence”.

It is the banks that really concern me. The share prices of some of Europe’s best known banks are trading near or even below their financial crisis lows. Deutsche Bank shares fell from €115 in 2007 to €20 in 2009. In 2010 they recovered to above €55. Now they are €12. Barclays, a bank that many considered “fixed” (as in “repaired” rather than fraudulent) trades 85% below its 2007 high but also 64% below where it had recovered to in 2010. And after eight years of endless repair work, RBS is down 98% from its all-time high but has more than halved in the last year.

The worst banks in Europe appear to be in Italy. 17% of all loans are classified as non-performing and there seems to be a need for another recapitalization with government money. But EU rules state that creditors must bear the losses and according to the press the German government is warning that Italy must stick to the rules. This could result in huge losses for private investors who own Italian bank bonds. Some alarmists (or realists) are warning that this inflexibility could deal another blow to the future of the EU as the Italian public could rebel in a big way.

I know that house prices are stupidly high and that capital expenditure is falling dramatically but the share prices of the banks tell me that something bad that I do not really understand is happening.

The price of any asset falls to a ridiculously low price when there are forced sellers. The news that some commercial real estate funds have suspended redemptions indicates that they feared that they would have to make fire sales of their assets. There has been a statement by the Financial Conduct Authority that “this is not a panic measure”. Well, I’m sure that it is perfectly sensible in the circumstances but we must never forget that all asset values are the product of risk and liquidity. This is what M&G, steward of a suspended fund had to say.

“Investor redemptions in the Fund have risen markedly because of the high levels of uncertainty in the UK commercial property market since the outcome of the European Union referendum. Redemptions have now reached a point where M&G believes it can best protect the interests of the funds’ shareholders by seeking a temporary suspension in trading. This will allow the fund manager time to raise cash levels in a controlled manner, ensuring that any asset disposals are achieved at reasonable values. “

Note that a) it’s not that they own overvalued illiquid assets but it’s all down to the referendum (which we knew was going to happen as soon as the Conservatives won the general election in May 2015) and b) the assets will be disposed of at reasonable values despite the fact that there don’t seem to be enough buyers at present.

Forced selling can be viral and can skip from one asset class to another.

The conclusion is that I sense that a significant buying opportunity is around one or maybe two corners. But buying opportunities are only for those with cash to invest. I think that many share prices are already too low but patience and nerve may be required. And I am continuing to look for opportunities to raise cash.   

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