2012 is likely to be remembered as another tough year for financial services.
Job losses have been high as new issues, corporate activity and turnover have dried up. Regulation continues to increase the cost burden on the sector and markets have remained volatile which has deterred investors from committing new money.
Our message throughout 2012 has been consistent; relatively low earnings valuations and healthy dividends have meant that investors are being ‘paid to wait’ for the economic upturn.
Meanwhile yields on cash and bonds remain poor.
Reasons to be bullish
As we enter December, however, we feel increasingly bullish as it is clear that some of the ‘tail risks’ have drastically reduced. Even if we do not experience meaningful economic growth in 2013, equity markets should start to anticipate an eventual recovery.
It appears the eurozone has agreed terms with the IMF which will enable Greek debt to be reduced by allowing a further injection of €44b billion of loans.
The crisis is far from over, but it appears that a default has been avoided and mechanisms are now in place to support troubled Sovereigns and banks if necessary.
Now uncertainty surrounding the election of a new US president has passed, attention has turned to the Budget Control Act of 2011 which could result in tax increases and spending cuts unless a highly partisan Congress reaches budgetary agreement by the year-end.
This has potentially significant negative consequences for both the US economy and, indeed, global growth if we reach this ‘fiscal cliff’ and consensus cannot be achieved. Nevertheless, we continue to believe that, on this occasion, politicians appreciate the implications of failure and will reach a compromise.
Even if these two issues are resolved, it will not provide a panacea to kick-start global economic growth but may, at least, reduce the probability and scale of the downside risk and provide a more stable environment for corporate and personal investment.
The problem with bonds
The purpose of Quantitative Easing is to keep the cost of borrowing low by distorting bond markets.
The UK government can borrow for 10 years at a cost of 2.4% p.a., despite the CPI running at 2.7%. There are many examples of companies taking advantage of this anomaly.
In the first half of the year GlaxoSmithKline issued a $2 billion 10 year bond yielding 2.85%.
This year the company is expected to buy back £2-2.5 billion of shares which currently yield 5.5%.
Similarly, Proctor & Gamble recently raised a €1 billion 10 year bond at an annual cost of 2.1%. The company also raised its potential stock repurchase programme to $4 -6 billion and its shares currently yield 3.2%.
It has paid a dividend for 122 consecutive years since its incorporation in 1890 and has also increased its dividend for 56 consecutive years. It is no surprise that companies are using cheap money raised in the bond market to buy back higher yielding shares.
While bond yields remain artificially low, many companies will use this arbitrage opportunity to boost earnings, improve cash flows and frequently reward shareholders with higher dividends.
Politicians realise that austerity is not an attractive proposition for re-election. Therefore, with printing presses running, many levers will be applied to stimulate growth. History suggests there is a balance between encouraging growth and controlling inflation further down the road.
Bank balance sheets continue to appear too large to us and behaviour suggests management is slow to realise losses and to pass on low borrowing rates to customers.
This is depressing growth. However, large corporates have direct access to bond markets and we expect this to be used to consolidate sectors and increase geographical coverage.
The low cost of borrowing makes this earnings enhancing and, hopefully, value creative. It is likely that corporate activity will pick up; a situation which will be well received by investors.
Bonds appear a much higher risk to us than a diversified portfolio of high quality equities.
While growth in the economy may still be many quarters away, markets typically discount events 18 months ahead.
Institutional holdings of equities have rarely been lower. We believe the balance of risk has improved considerably. 2013 promises to offer very healthy returns for equity investors.