Financial Forecast. Issue No. 7 September Inside this issue. Indices / FX Rate. Key Investment Thoughts 2. Global Macro Thoughts 3

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1 Issue No. 7 September 2010 Financial Forecast Inside this issue Key Investment Thoughts 2 Global Macro Thoughts 3 Equity Markets 8 Fixed Income 10 Currencies 12 Commodities 14 Conclusion 16 Indices / FX Rate Price (prices as at 13 th September 2010) FTSE 100 5, DJ Eurostoxx 50 2, S&P 500 1, / $ Crude Oil Gold 1,245.6 This report is written to place global financial markets into perspective and to draw together the future themes that we are formulating and subsequent trade ideas. RMG Wealth Management LLP 13 Austin Friars London EC2N 2HE Tel: Fax: Stewart Richardson Chief Investment Officer RMG Wealth management LLP info@rmgwealth.com Website: RMG Wealth Management LLP is authorised and regulated by the Financial Services Authority Registered in England No. OC Registered office is at 13 Austin Friars, London, EC2N 2HE

2 Key Investment Thoughts Equity Markets The Summer months have been frustrating for equity market investors. There has been very little net change over the last 12 months now, and at some point, we know that markets will break out of this sideways pattern. We continue to believe that the risk is for a break to the downside in the weeks ahead. Interest Rates Government bonds markets in the US, UK and Germany performed very well again in August. Having been bullish since mid April, we reduced exposure at the end of the month, booking a very healthy profit. We are looking for a period of consolidation in the weeks ahead so that we can rebuild our holdings. We continue to expect core Government bonds to outperform most other assets in the months ahead. Currencies Last month, we stated that we felt the correction in the US Dollar was nearing an end. Since then, the Dollar has risen by nearly 3% against a basket of currencies. This move up in the Dollar has taken a number of investors and commentators by surprise. We expect the Dollar to make broad based gains between now and year end. Commodities Commodities have been mixed over the summer months, with a firmer bias. We expect the more industrial commodities to trend lower as economic growth disappoints in the months ahead. Agricultural commodities appear to be very attractive at current levels. We are agnostic on Gold at the moment. Conclusion The next few weeks are probably going to be very important for financial markets, and whatever the trend emerging from the current consolidation will likely set the tone for some time to come. Chart 1 the US Equity market since late Sideways and frustrating. Last month, we noted that Markets do not move sideways forever, and we still believe that the risk of a downside break in the months ahead is very real. The S&P 500 has traded down to the 1,040 area a number of times in the last few months, as denoted by the blue arrows. The 1130 to 1150 area remains resistance as denoted by the red arrows. 2

3 Global Macro Thoughts What is happening to UK Housing? Recent data on the UK housing market is showing signs of slowing down over the summer months. Does this slowdown presage lower prices in the future? If so, what does that mean for the economy and the financial markets? The Nationwide Building Society released figures two weeks ago that showed UK house prices fell by 0.9% in August, having fallen by 0.5% in July, the first back to back declines since the first quarter of The HBOS house price index declined in each month during the second quarter. The August RICS house price survey moved further into negative territory, and is now back to the same level in May The index fell to -32% which is consistent with falling house prices in the months ahead. The Rightmove survey shows house price declines in both July and August. The Hometrack survey shows house price declines for both July and August. The Bank of England and the British Bankers Association continue to report very low levels of new mortgage activity in recent months. The facts set out above illustrate that there really is very little doubt now that UK house prices have stopped going up. Chart 2 Nationwide House Prices with Year on Year % Change The chart above plots the value of average house prices in the UK (Nationwide Building Society) together with the year on year percentage rate of change. The decline in prices between late 07 and early 09 was very meaningful, totalling a little over 20% (so much for house prices never going down!). The rebound since February 09 has 3

4 reclaimed approximately 60% of the decline, but as can be seen on the chart and the facts on the ground, the rebound seems to be stalling. The weekend FT of 4 th and 5 th September leads with the headline New homes data spell declining market. In the article, the paper refers to an internal weekly survey conducted by the House Builders Federation that is regarded by the industry as the best guide to housing demand. The FT notes that deposits on new properties have fallen below those recorded in A chief executive of one of the UK s largest house-builders said the data were worrying, highly significant and consistent with a falling market. Later in the article, the FT quotes everybody in the industry thought they had died and gone to hell in 2008, said one industry official familiar with the figures, noting that times seemed worse now (emphasis added). With the Bank of England having held interest rates at 0.5% since January 2009 and flooded the banking system with 200 billion of cash through their quantitative easing programme, why is the housing market seemingly rolling over? Surely this was not supposed to happen. What is really important for measuring the health of the housing market is not just price, but also the amount of activity. Typically, the number of transactions will peak well before price, or put another way, house prices continue to go up even when there are fewer buyers willing to pay the higher prices, but only for a relatively short period of time. Chart 3 Nationwide House Prices with Mortgage Approvals Chart 3 illustrates the relationship between house prices and the number of mortgage approvals (a reasonable proxy for activity). As can be seen, mortgage approvals peaked at over 80,000 per month in 2001, and higher house prices between 2001 and 2007 were supported by lesser activity as measured by mortgage approvals. We would argue that the lower mortgage activity is a sign that, on balance, potential house buyers are less interested in paying higher prices. Why would potential house buyers be less interested in paying higher prices? We believe one factor is affordability, or put another way, perhaps potential buyers in 2007 began to realise that they just could not afford to buy a property given historically acceptable financing practices (as we know, the so-called financial innovation that created exotic mortgage products allowed too many people who frankly could not afford a house to buy one). 4

5 Chart 4 Nationwide House Prices with Affordability Ratio This chart illustrates how the affordability ratio (the ratio of the Nationwide First Time Buyers Index to average gross earnings) rose steadily from the late 1990 s. Having historically been in a range of 2.5x to 3.5x, the affordability ratio exceeded 5x as house prices were peaking in late This is not just a coincidence. We understand that with interest rates as low as they are today, the servicing of mortgage debt is lower, and all other things being equal, some would argue that house-buyers should be able to borrow more relative to their current earnings. There are two problems with this thinking, both linked with our belief that we live in a post credit bubble period characterised by low growth, anaemic wage growth and balance sheet repair. First, when wages were growing at 4% or 5% per annum, it was a widely accepted view that even if a borrower stretched themselves when taking out a mortgage, a steadily rising salary would make the monthly mortgage payment more affordable over time. The problem today is that salaries, as shown in chart 5 below, are growing significantly less that they were during the last decade. Furthermore, as the UK Government embark on their programme of fiscal austerity, which will definitely mean significant job losses, wage growth will likely remain anaemic. We believe that the British public understands this, and as a result, is less willing to borrow large sums of money relative to their salary. Second, during a balance sheet repair process, it is not liquidity that matters but the amount of debt. Just as happened in Japan during the last 20 years the private sector, having seen their balance sheet impaired by falling asset prices, are now focused on debt minimisation. This process is more clearly seen in the U.S. where consumers have been consistently reducing outstanding debt since Q In the UK, net debt is still increasing each month, but by about 1 billion compared to more than 5 billion before the financial crisis. 5

6 Chart 5 UK Average Earnings Of course, most commentators seem to be blaming the banks for their lack of lending and demanding large deposits before they will lend. However, it is worth noting that there are two parties to a loan transaction, and recent data suggest that it is the lack of demand as much as the lack of supply that is inhibiting activity in the housing and mortgage market. As the FT said in a recent article, Homeowners feel that rates are so low it is more worthwhile to repay their mortgages than to deposit cash net mortgage lending after repayments in July was the third lowest since records began in But hold on a minute, text books tell us that low interest rates are supposed to spur demand for loans and higher interest rates are supposed to curtail demand for loans. Why then are UK consumers repaying mortgages now that interest rates are relatively low? Why are they not looking to borrow more money to buy more or bigger houses, because house prices always go up, right? Well, in a post bubble environment, things are different. Monetary policy becomes ineffective because borrowers are more interested in balance sheet repair. Chart 6 below is taken from a recent McKinsey report and illustrates just how much debt was created during the last two decades, relative to GDP. Every sector of the UK economy (the Government post 2008) dramatically increased levels of debt relative to GDP, and whereas the corporate sector (both financial and non-financial) have reduced debt a little since Q1 2009, Household debt remains broadly the same. McKinsey have analysed a number of previous credit boom and bust cycles, and they calculate that it takes 5 to 7 years to work off the borrowing excesses, and that debt to GDP shrinks by a quarter. If the U.K follows this path, then approximately 1.5 trillion of debt at today s value has to be retired (or written off!) in the next few years. The message here is that households are unlikely to take on new mortgages until their balance sheets have become less leveraged and they start to earn more in salaries, a process that will not be fully achieved for several years. 6

7 Chart 6 UK Borrowing as a % of GDP 1987 to 2009 Conclusion The credit bubble in many developed markets developed over more than 10 years, and we believe that working off the excesses will be a multi-year process. We have not experienced such a credit boom and bust in our lifetimes, and we have drawn upon the recent Japanese experience for some of our analyses. Frankly, the similarities between the West today and Japan in the 1990s is rather disturbing. If we are correct, house prices are unlikely to move significantly higher from here until the excesses that built up have been removed. If house prices actually go back down again, as some well respected forecasters are now arguing, this will further impair household balance sheets and bank s balance sheets. Furthermore, if U.S. house prices decline as well as UK house prices (which we believe is very possible) then this will very likely have a negative influence on both economic growth and equity prices in most developed markets. We saw in 2008 just how important house prices were for the performance of the financial sector, the economy and the markets. We are therefore watching closely to see whether the squishy data of the last month or so is just a soft patch, or the start of another leg down in the UK housing market. 7

8 Equity Markets Equity markets participants seem to be engaged in a huge tug of war at the moment. Chart 1 of the US equity market on page 2 illustrates the trend that has been seen across the majority of developed markets, i.e. no significant change has been seen for many months. What seems to be frustrating the hell out of most people is that there has been a lot of noise during this sideways movement, and now very few people have any level of conviction in their views. As a result of this, trading activity has dropped to very low levels which then allows short-term traders (who account for over half of turnover) to move the market around way that just does not make sense to anyone.. As far as we can tell, there are three tenets to the bullish equity story. First, corporate earnings have been growing strongly, and will continue to do so. Second, valuations are cheap when looking at current forecast earnings. Third, equities look cheap compared to Government bonds and cash, where yields are at historically low levels. We have discussed the valuation of the market in past reports, and continue to believe that the market is actually overvalued, not undervalued, when using tried and tested criteria. When we look at earnings, we believe that the outlook is dimming here quite quickly. Chart 7 Analyst revisions compared to actual earnings growth in the US Chart 7 above shows in red the change in analyst earning expectations with the year on year change in actual earnings in black. Usually, analysts are a pretty chirpy bunch, and the fact that they are cutting earnings as quickly as they are should be troubling for the market. With regard to the market offering a relatively attractive dividend yield compared to Government bonds and especially cash, this is true. That said, equity investors have to accept that moving assets into equities to capture this relatively attractive yield comes at price. Initially, that price is a much higher level of volatility. Of potentially greater importance, if dividends were ever reduced, this would have a dramatic effect on the capital value of such investments, and would cause investors seeking this investment rationale to question whether it remained appropriate. I see two problems on this search for yield strategy. First, interest rates are at low levels for a very good reason, which is that there are some very large structural headwinds at the moment and central bankers are trying all they can to support developed economies that are essentially not able to support themselves. Second, the problem here is that these ultra low interest rates are encouraging some (possibly many) savers to invest cash 8

9 into higher yielding and higher risk assets. When investors feel compelled to take on more risk than they would otherwise do, this is known as speculation, and is not healthy. We would make one more point surrounding cash. Although there is undoubtedly a lot of cash sitting on the sidelines this has to be tempered by the record debt levels, and the fact that balance sheets remain very strained. A useful indicator that we follow is the cash to total assets ratio in US mutual funds. This ratio fell to 3.4% as at the end of July which is the latest data available. This means that institutional mutual fund managers are holding the lowest level of cash in their portfolios since records began in This is a sign of how bullish this group of investors are as surely they would be holding much higher levels of cash if they were bearish. Chart 8 below is one that we have shown before, and it shows that when mutual fund managers are holding very high levels of cash, it is a good time to buy equities, and when they are holding low levels of cash as they are today, it is a bad time to buy equities. Chart 8 Cash to total assets for U.S. mutual funds We have not been able to update this chart to illustrate the new record low in cash levels, but we hope our point is made. We believe that equity markets are not attractive at the moment, with valuation unattractive, earnings growth set to disappoint, and with little cash, or buying power left to push prices much higher. We ve said it before, but we ll say it again. The equity market is pricing in a near perfect V-shaped recovery in the economy and we believe that this is unlikely to happen. As the data disappoints between now and year end, we expect equity markets to struggle on the upside, with the risk of a new downward trend quite high. 9

10 Fixed Income Markets Government Bonds The performance of core Government bond markets has been absolutely stunning in the last few weeks, as investors realise that high quality assets that generate a stable income are actually attractive in a low growth, balance sheet repair environment. Every strong bull market, however, must correct from time to time, and when the 10 year Gilt yield was dropping down to 2.80%, we felt that it was time to book some profits and wait for such a correction. Chart 9 The yield on the 10 year UK Gilt (lower yields mean higher prices) The above chart shows that since earlier this year, Gilt yields (which move inversely to price) have fallen from 4.25% to 2.80%, although since the recent low have bounced back to 3.15%. There is much debate in the media about whether Government bonds are in a bubble. We think not. With European Governments set to embark on the most aggressive fiscal austerity programmes since WWII, economic growth is set to slow quite dramatically at a time when households in particular remain in balance sheet repair mode. On the flip side, we have central banks that seem keener to expand their balance sheets through further quantitative easing (printing new money to the rest of us). At the moment, the money that is being printed is struggling to reach the real economy and seems to be getting stuck in the banking system. The chart below shows M4 money supply in the UK. This is the broadest measure of money supply and is shown as a year on year percentage increase. What is striking is that even with the creation of 200 billion in new money through the Bank of England s Quantitative Easing programme, money supply growth is at the lowest level since records began in We would argue that aside from lowering the cost of borrowing in capital markets for large companies, the Quantitative Easing experiment has not been nearly as successful as the Bank of England would have liked. Money supply is barely growing because the newly created cash is getting stuck in the banking system. This is because both sides to a lending transaction, the lender and borrower, are both reluctant to enter into new transactions, and in fact, a number of borrowers are looking to reduce debt. 10

11 Chart 10 The growth in UK money supply is collapsing despite 200 billion in QE! We believe that the process of balance sheet repair is counteracting the money printing from central banks, and until the psyche of UK households changes from debt minimisation to taking on new debt, quantitative easing will have little impact on the real economy. Quantitative easing will help boost asset prices, even if only for a short period of time, and Gilt prices will be a major beneficiary. Therefore, the potential for further printing of money to buy Gilts gives us a technical reason to remain constructive as well as our fundamental view that the economic environment is supportive of reasonable returns from Government bonds. 11

12 Currencies At the beginning of August, we said that we thought that the US Dollar correction was close to ending, and since that time, Both the Euro and Sterling have declined by approximately 3%. Chart 11 The Sterling/US Dollar exchange rate with bullish sentiment The above chart illustrates the performance of Sterling versus the US Dollar together with bullish sentiment. Our primary view is that as the fiscal austerity programmes gets going, UK economic growth will moderate very quickly. Furthermore, we fully expect the trend for global deleveraging to be supportive for the US Dollar just as it was in With bullish sentiment towards Sterling at neutral levels, we think that there is room for the market to get more bearish here, and over time, we expect Sterling to break back below Elsewhere, we have been steadfastly bullish of the Swiss Franc against Sterling for the last few months. Chart 12 below shows the Swiss Franc rate against Sterling (the lower trend depicts Sterling weakness). The blue horizontal line highlights a shelf of support for Sterling at around 1.58, and this support is in the process of being broken. Within our macro theme where we expect safe haven assets to perform well, the Swiss Franc should perform well, and with support in the process of being broken, we see little getting in the way of the Swiss Franc trading down to 1.50 over time. 12

13 Chart 12 The long term picture of Sterling declining versus the Swiss Franc Elsewhere, we remain constructive on the Norwegian Krona and Japanese Yen versus Sterling, although we are the first to admit that Japan s structural problems will come home to roost at some point. Chart 13 Sterling versus The Norwegian Krona Sterling is in a long term bear market here The chart above illustrates the long-term downtrend for Sterling versus the Norwegian Krona. The recent bounce in Sterling has corrected an oversold condition, and we expect the down trend to continue. 13

14 Commodities The dispersion of returns between the various commodity sub groups appears to be increasing, which we think is a good thing as it offers investors a greater chance of finding uncorrelated trade ideas. Generally speaking, we believe that industrial commodities (oil and base metals) are vulnerable to a downshift in the global economy, and we have just put in place a small bearish trade in oil to reflect this view. The agricultural commodities appear to be in a strong bull market, supported by supply concerns, and we have a small bullish exposure to wheat. Elsewhere, we are reasonable agnostic, noting only that Gold appears to be struggling to break out above the previous high around $1265 in June. Chart 14 The price of U.S. Oil since 2005 The above chart shows the price of oil over the last 5 years. After the collapse in 2008, the price rallied along with other risky assets in 2009, and for months now has been tracking more sideways than anything else. Industry analysis points to significant excess supplies of oil at the moment. One way of illustrating this is that the price of oil for delivery in December 2011 is 8.5% more than for delivery in October What this means is that traders can buy oil today, and sell for delivery in December 2011 and make an 8.5% profit before storage costs. This trade of buying now and selling for future delivery has become very widespread and indicates that supply will be plentiful in the future. This excess supply together with our cautious view on global growth (which may well mean slightly lower demand next year) should be bearish for prices, and we are comfortable with our bearish view on oil. The agricultural sector has been strong of late as Russia confirmed fears that it s harvest had been sufficiently impaired that they will most likely not export any wheat until next year. There have also been other fears over harvests in Europe and also Argentina, and this we believe will be supportive of prices into

15 Chart 15 The trend in wheat is bullish for the months ahead The above chart shows how wheat, having performed strongly over the summer, has corrected during August in quite an orderly manner. This type of correction is usually followed by higher prices, and we expect the summer high around $850 to be exceeded in the weeks/months ahead. Chart 16 A long term bull market but struggling at the recent high? By way of a quick update on Gold. Price appears to be struggling at the June high and momentum shown in the lower panel looks like it wants to rollover. The media seems to paint Gold in a win/win situation depending on whether one is a deflationist or an inflationist. We do not know of any investment, including Gold, that can go up in every scenario, and so this win/win talk does make us nervous that the upside for Gold is limited in the short term. 15

16 Conclusion Financial markets have been erratic in nature over the summer months, frustrating us and many other investors alike. The cross-currents between an ever more cautious macro landscape and the ever bullish equity market appear to be close to a resolution. What we need to see from equity markets is a breakout from the near year long trading range, accompanied by rising volume which would indicate conviction in a new trend. Our bias is still to believe that the equity market will break out of the range downwards. Within other assets, the safe haven theme within a deleveraging environment is working nicely in our favour, and we broadly expect more of the same. We believe that the next month or so will be important in determining the trend for the next 6 months or more, and so we paying particular attention. Disclaimer RMG Wealth Management LLP is authorised and regulated by the Financial Services Authority (FSA). This report is for general information purposes only and does not take into account the specific investment objectives, financial situation or particular needs of any particular person. It is not a personal recommendation and it should not be regarded as a solicitation or an offer to buy or sell any securities or instruments mentioned in it. This report is based upon public information that RMG considers reliable but RMG does not represent that the information contained herein is accurate or complete. The price and value of investments mentioned in this report and income arising from them may fluctuate. Past performance is not a guide to future performance and future returns are not guaranteed. 16