Financial Forecast. Issue No. 5 May Inside this issue. Indices / FX Rate. Key Investment Thoughts 2. Global Macro Thoughts 3.

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1 Issue No. 5 May 2010 Financial Forecast Inside this issue Key Investment Thoughts 2 Global Macro Thoughts 3 Equity Markets 7 Fixed Income 10 Currencies 12 Commodities 14 Conclusion 15 Indices / FX Rate Price (prices as at 25 th May 2010) FTSE 100 4, DJ Eurostoxx 50 2, S&P 500 1, / $ Crude Oil Gold 1, 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. Our sister publication, the weekly report, will pick up on specific trade ideas. RMG Wealth Management LLP 13 Austin Friars London EC2N 2HE Tel: Fax: info@rmgwealth.com Website: Stewart Richardson Chief Investment Officer RMG Wealth management LLP 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 Global Markets Global markets turned lower in quite dramatic fashion in May. Whatever the reasons for this sell-off in risk assets, it appears to us that this could be the start of a more serious decline that may take markets lower over the months ahead. Stock Markets Equity markets are now testing critical support levels. Most western markets are now trading below their average level for the last 200 days, and by definition, all great bull markets must see price greater than its own 200 day average (see chart on page 7). The next few weeks should be critical. If markets cannot mount a reasonable rally from the current oversold condition, then we fully expect to see lower prices in the weeks and months ahead. Interest Rates Government bond markets have benefitted from a flight to safety during the recent sell-off in risk markets. With fiscal retrenchment becoming widespread, the fundamentals for Government bonds may be getting less worse. Despite being overbought in the short-term, we believe that Government bond prices will rise further in the months ahead. Currencies The US Dollar has continued to move aggressively higher in the last few weeks. We expect further US Dollar strength against most currencies in the months ahead, although after the huge move in the last few weeks, now may not be the optimum time to be aggressively long the US Dollar. We have booked some profits in our portfolios and will look to re-enter at better levels. Commodities The majority of commodities have also suffered in the recent sell-off. We see no reason to expect commodities to decouple from other risk markets. We therefore expect lower prices ahead if equity markets continue lower. Conclusion After the recent sell-off in risky assets, we are at critical levels that must hold if markets are going to go up in the months ahead. We suspect that markets will fail to rally, and lower prices lie ahead. We have managed to navigate the recent turbulence well with client portfolios that we have been managing since February up 5% since that time. We expect to maintain our defensive posture for the foreseeable future. Is the Aussie Dollar versus the Japanese Yen the canary in the coal mine? 2

3 Global Macro Thoughts Here is a recent quote from a Bloomberg columnist talking about whether Europe will face a Japan-like lost decade. One could easily be on the cards. Like Japan, Europe seems mired in an old and storied civilisation that has given way to a sclerotic bureaucracy, mountains of debt and a growth-killing unwillingness to make hard decisions. It s wedded to an outdated image of its pivotal role in the global economy and doing little to maintain it. This is possibly the most eloquent quote I have seen on the overall standing of Europe today. The recent reaction (very poor that is) of the markets to both the EUR110 billion bailout for Greece and then the EUR750 billion support package for the rest of Europe shows that the problems afflicting Europe are very deep indeed. The fact of the matter, as outlined in our report of 10 th May 2010 is that the problem is not one of liquidity, but one of solvency, or to put it another way, debt levels throughout most of Europe are just too high. There is no easy answer to this problem. In days gone by, struggling countries would devalue their currency to improve their competiveness, and occasionally, a debt restructuring would have occurred as well. Furthermore, western countries have always enjoyed a level of inflation that eroded the nominal value of outstanding debts. Today, despite the unprecedented stimulus that policy makers have unleashed in the last two years, inflation in Europe and the US (and in our opinion the UK as well) is headed towards zero (see chart below for US). So, without the inflation get out of jail free card, and no current devaluation route available, the only route to repairing the public finances is to cut costs and raise taxes and just pray that the economy can grow its way out of the problem. At the same time, the whole southern European belt has become significantly uncompetitive over the last 10 years. It is estimated that on a relative basis to Germany, costs have to come down by 30% or so. As has been seen with the strikes breaking out throughout southern Europe, the social burden of the austerity measures is hard to accept. Indeed, looking at Ireland as an example, budget finances are actually forecast to worsen this year despite austerity measures put in place in The level of pain throughout southern Europe may get a lot worse before the fiscal imbalances make any significant improvement. A big worry about this drive towards fiscal austerity throughout Southern Europe is that the effect will be to dampen economic growth at the very least. We actually believe that these countries will slip back into negative growth later this year, and some countries will not even emerge from recession. 3

4 What is worrying from a global perspective is that it is not just southern Europe that is racing to implement fiscal austerity packages. The UK has already announced 6 billion of savings ahead of an emergency budget on 22 nd June. Germany is set to reduce their deficit by EUR10 billion per year starting next year. Italy have just announced spending cuts of EUR30 billion. The United States have established a working committee that will report back before the end of the year on how to tackle the budget deficit. Basically, the debt problem is not isolated to southern Europe, but is widespread in the western world, and the workout period to reducing these debt levels will be an arduous process. In the meantime, the risk to growth from this co-ordinated drive to fiscal austerity is increasing. Our base case is that the combination of the excessive debt levels at the household and Government levels, couple with widespread moves towards deficit reduction and a growth slowdown in China will lead to a much lower level of economic activity during the rest of this year and into 2011 than the consensus currently predicts. There is also now a much greater risk of a double dip recession which is definitely not consensus. In either scenario, we believe that equity markets are overvalued and Government bonds offer fair value. Back to whether Europe, and for that matter the UK and US, is more like Japan than most of us would care to admit? Well, we believe that the answer is yes. What happened in Japan seems to be happening in the western economies today, and although there are differences, the similarities are becoming too obvious too ignore. In the 1980 s Japan experienced a boom in asset prices (e.g. equities, property and golf club memberships) that was in part fuelled by a rapid increase in debt. These debt levels seemed to be fine so long as asset prices kept rising. Sound familiar? The problem came when asset values started to collapse. As this occurred loan to value ratios ballooned, and in some cases, debts exceeded asset values. Because the debt problem in Japan was focused in the corporate sector, we can characterise this situation as companies moving towards or even into negative book value. It is also worth noting that both corporate executives and bank managers spent a lot of time trying to cover up this move into negative equity, and so long as companies were able to generate current profits and service their debt, the situation was quietly ignored. The parallel in the west is that the original debt binge was focused in the household sector where the largest asset is property. When the loan exceeds the value of the property, negative equity resulted, which has become quite widespread in the US and is increasingly found in the UK and parts of Europe. Richard Koo an economist at Nomura has undertaken some excellent research into what happened in Japan, and terms the whole process just described as a balance sheet recession. When Japan nosedived into recession in the early 1990s, the Bank of Japan slashed interest rates towards zero per cent to encourage a recovery, but contrary to economic theory that the private sector in aggregate seeks to maximise profits, the corporate sector sought to minimise debt. The data in Japan shows that even with interest rates at close to zero, corporate Japan reduced debt between 1992 and 2007 and this was voluntary in most cases. Between 1992 and 2003, corporate Japan financing swung from a 10% deficit of GDP to a 10% surplus, and this 20% total swing would ordinarily have moved the economy into a depression similar to that seen in the US in the 1930s. In the early 1990s, the Japanese Government s finances were in reasonable shape, and as the corporate sector contracted, the Government borrowed and spent heavily (a fact that is now being widely discussed as their gross debt levels approach 200% of GDP, higher than any Eurozone country). This action by the Government prevented the economy from moving into depression but with corporate Japan focusing on debt minimisation and balance sheet repair, there were very few buyers of Japanese assets and as we know, the equity and property markets remain 75% to 90% below peak 1990 levels. 4

5 So what is happening in the west today? Data in both the US and UK show that private sector debt is contracting (see chart above for US) and the contraction began in early 2009 after central banks has slashed interest rates close to zero per cent. Economic agents are focusing on debt minimisation rather than profit maximisation. We also know that western Governments have borrowed and spent heavily to try and engineer an economic recovery, which we believe is very sub-par compared to other recoveries. As noted, there are both similarities (which we hope we have illustrated here) and differences between Japan in the 1990s and the west today, the main one being that the worst debt excess has occurred in the household sector as opposed to the corporate sector. The consumer sector in western economies accounts for approximately 70% of economic activity compared to less than 20% for the corporate sector, and so if the consumer sector is set for a decade or so of balance sheet repair, this is a big deal. Of course, there are potential solutions. For example, banks could forgive a certain portion of outstanding consumer debt possible but not likely! The Government could commit to the banks in backstopping or taking over a certain portion of outstanding debt again possible, but Government finances probably preclude this. As with previous periods in history such as the 1970s, we can let inflation wipe out the nominal value of outstanding debt, although it is our belief that inflation is headed towards zero and so this solution will not work. Or, the most likely solution is that consumers will have to save to reduce debt. The problem with this solution is that organic income growth is basically non-existent today, and is unlikely to increase any time soon. So unfortunately, it would appear to us that consumers will have to save more by reducing expenditure, and of course this will have a negative impact on economic growth. 5

6 If our thesis that we are all turning Japanese is correct, and we want to ensure that our economies avert a 1930s style depression, our politicians had better try and learn from the Japanese experience. Western Governments are hell bent on reducing spending and raising taxes in an attempt to tackle ballooning budget deficits and sky high debt to GDP levels, all of which seem sensible policies on the surface. However, this move towards fiscal austerity may not be such good news. Twice in the post 1990 period, the Japanese Government moved to address their increasing fiscal imbalances, and in both periods, tax revenues fell, the budget deficit rose and the economy fell into recession. These macro thoughts really are only scratching the surface of the comparison between Japan in the 1990s and the west today. We intend to update these thoughts in future notes. 6

7 Equity Markets In our last two issues, we have presented some of the fundamental indicators that we believe show that equity markets are overvalued, over-owned and vulnerable to a correction. What had been missing up until this month was a declining trend in price. One of the simplest indicators that we use to identify a market s major trend is the direction of the 200 day moving average. The chart below shows the S&P 500 since 1970 using the 40 week moving average (a reasonable proxy for the 200 day moving average), and as can be seen, the best bull markets are associated with a rising 200 day moving average. Analysing the actual data, we have two models which need only a little bit of filtering. First, a buy and hold approach whereby we buy as the 200 day moving average starts to rise, and we then exit when the average begins to decline. The second model is the same as the first except we actually go short when the average begins to decline. The first model, or our long only model, would have seen US$10,000 invested in January 1970 increase to US$137,000 today, and would only have been invested for 70% of the time. A simple buy and hold approach would have seen US$10,000 increase to US$117,000. The second model, or our long/short model, would have seen US$10,000 invested in January 1970 increase to US$181,000. Both these models significantly improve on a buy and hold approach, with the long only model reducing risk as well. Although no model is perfect, we do believe that the fact that most major equity markets are now trading below their own 200 day moving averages is indicative of a trend that is turning from bullish to bearish. If and when the 200 day moving averages actually turn lower according to our filter, we believe that the onset of a bear market will be confirmed. This could very well happen in the next few weeks. 7

8 The one draw-back on these moving average based models is that moving averages are lagging indicators, and so are of less value in pinpointing turning points. We have a number of other indicators/models that we use in trying to pinpoint turning points or corrections. The above chart shows the S&P 500 on a weekly basis with momentum in the lower panel. First, I have indicated on the chart a negative divergence between price and momentum at the recent high in April. Basically, a strong bull market should exhibit strong momentum, and although divergences do not guarantee a market turn, they are present at many turning points. This is a good example of one of the technical indicators we use in judging the health of markets. If the 200 day moving average on the S&P 500 does turn lower as we suspect, the fact that weekly momentum is only just rolling over from an overbought level indicates that there may be plenty of room on the downside if the market so chooses. This chart shows the FTSE 100 on a daily basis with momentum in the lower panel. As can be seen, momentum is reaching a relatively low level at a time when the index has come down to test chart support in the 4,900 to 5,050 range. 8

9 So, although it appears that there is plenty of room on the downside looking at the weekly chart, there is absolutely the potential for a short-term bounce looking at the daily chart. This is why we believe that the short term is so important, and when looking at FTSE100, if the 4,900 level is broken on the downside, the bear market case will gain further credibility. One issue that we hear from the bull camp on a daily basis is that the market is cheap when comparing price to forecast earnings or dividend yield to 10 year gilt yields. Unfortunately, not only does the forecast earnings method have a poor track record, but these bullish positions are predicated on a normal type of economic recovery with normal earnings growth and margin expansion. We believe that the main problem with these bullish positions is that this is not a normal recovery. We have set out some thoughts in the Macro section that follows. Basically, we believe that economic recovery has been highly dependent on the extraordinary monetary, liquidity and fiscal policies that have been put in place, and that the reality is that when stripping out these stimulative measures, the recover since last year has been the weakest on record. Furthermore, the west is probably more like Japan that policymakers care to admit. This is covered in the Macro section, but if we are anywhere near close on this premise, and the Japanese roadmap proves useful, then we will be right to be defensive on equity markets in the months ahead. 9

10 Fixed Income Markets Government We started buying Gilts and US Treasuries last month as we felt that not only were the inflation and supply factors fully discounted by the market but also because it was very difficult to find anyone who was really that bullish on these assets i.e. a great contrarian trade. As can be seen in the chart below, the yield (which moves inversely with price) on the 5 year Gilt has broken out of the well defined trading range that has been in place for over a year. This breakout is a very powerful signal. Our feeling is that a large number of institutions are underweight in Gilts and will be feeling a bit sore on missing the recent rally. We suspect that these institutions will be buyers of Gilts on any pullbacks, and we know from official data that commercial banks have been buying bonds to hold on their own balance sheets. Simply put, in a more uncertain world, investors will likely search out yield on assets that they view as high quality, and despite what many commentators will have us believe about the state of the UK finances, UK Gilts are amongst the highest quality assets that a UK investor can hold. We will be using any weakness in bond prices as an opportunity to increase exposure further. Corporate Bonds Corporate bonds must be classified within the risky asset bucket, so it is not surprising to see corporate bonds underperforming treasuries during the recent global sell-off. As noted in the Global Macro section, we believe that economic growth in many parts of the world is set to disappoint as fiscal austerity becomes trendy and debt minimisation rather than profit maximisation drives decision making in the consumer sector. If our predicted slowdown then morphs into a double dip recession, corporate revenues and earnings will come under pressure, and the market would then demand a higher return relative to Government bonds as compensation for holding corporate bonds. What worries us further is that corporate bonds have been a huge beneficiary of the search for yield in a near zero interest rate environment. For example, in the US, whereas equity funds have seen virtually no net inflows over the last 12 months, non Government bond funds have received about US$300 billion in new money. Just what would investors think if all of a sudden they started to lose money on these new investments? Our best guess is that they would be pretty unhappy and would move quite quickly to liquidate their holdings. 10

11 The above chart shows the yield differential between high yield corporate bonds in the US and Government bonds. As can be seen, in the last few weeks, the differential has widened by approximately 2%. Importantly, the differential is wider (higher in this case) today than it was in February when the Greek crisis first hit markets. This is perhaps a subtle clue from the credit markets that this time will be different and that risky assets are not about to embark on another bull run. This chart shows the rate of 3 month Libor in US$. As can be seen, rates for 3 months have moved higher since March. This is not a sign that the US are about to raise interest rates because the economy there is doing well. It is a sign that Banks are nervous about lending to each other for periods of 3 months. If the banking system begins to freeze up again, how will Governments bail them out when they are already bailing out southern Europe? Who will guarantee the guarantors? Basically, the action in the credit markets is pointing to further strains ahead, which only bolsters our position of investing in high quality Government bonds and avoiding corporate bonds. 11

12 Currencies The US Dollar has been strong against everything except the Japanese Yen. The Euro remains the whipping boy and the commodity currencies are playing catch up. It seems like a well-worn path, but the strength in the US Dollar just continues unabated despite being overbought under any normal analysis. Clearly, the reserve status mandates that the US Dollar benefits from safe haven flows during times of distress. Furthermore, the current perception is that the US economy will exhibit higher future growth than other developed economies which is a positive, but most of all, the trend towards debt reduction (which is gathering pace) helps the US Dollar as globally borrowers buy US Dollars to repay debt. The above chart shows the Euro versus the US Dollar since March 2009, with momentum in the lower panel. What is striking is just how oversold the Euro is. Visually, we can see that the disparity between price and the 55 day moving average (the red line) is greater than at any time in the last 14 months, and the momentum indicator is also at the lowest level during the period. The point here is that it would not be surprising to see the Euro bounce in the weeks ahead, as it is extremely oversold, but if it does bounce, we suspect that it will be a bear market bounce. In the last two or three weeks, the cyclical currencies such as the Australian Dollar (the previous poster child of the currency markets) have been hit hard. This could be a simple case of position unwinding, but we also believe that it is symptomatic of a deteriorating economic outlook that markets are now adjusting to. Similar to the weekly chart of the S&P 500 on page 5, the weekly chart of the Australian Dollar shows that momentum has only just begun to rollover from an overbought level. As can be seen, if the current situation becomes comparable to that seen in 2008, the Australian Dollar, as a proxy for other cyclical/commodity currencies, may have a long way to fall. 12

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14 Commodities Commodities have generally suffered during the recent bout of risk aversion, with only Gold able to hold its own. As can be seen in the chart above of Gold, although the price has slipped by about US$50 or so in the last two weeks down to US$1200, the trend since summer 2009 is up. The only reason that we can think of for a decline in the price of gold in the weeks ahead is because it is over owned and investors/traders may take profits to help cover losses incurred on other assets. One major reason for being bullish of Gold today is to make a comparison between the environment now and that prevailing in Back in 2008, as the financial crisis was really getting going, Gold actually declined from US$1,032 in March 2008 at the time of the Bear Stearns collapse to US$682 in October 2008 at the time of the Lehman Brother collapse. This is a good example of how even a safe haven asset can go down in price because of unwinding if excess long positions. Today, however, rather than navigating a corporate/financial sector crisis, markets are now having to deal with a sovereign debt crisis. The financial credibility of the guarantor of the financial sector is now being called into question, and there is a good case to be made that Gold should hold its value during a sovereign debt crisis. Although we have not previously bought gold for our clients, and are somewhat loathe to buy at today s prices, we are warming to Gold s safe haven status as the sovereign debt crisis evolves. Within the rest of the commodity complex, the more cyclical commodities as noted have suffered in the last few weeks. The chart on the next page shows the price of oil. The well defined bullish channel that has been in place since last summer has been broken on the downside and the trend appears to have changed from bullish to bearish. This change in trend is symtomatic of the growth slowdown or double dip recession outlook that we believe will become more widely accepted as the year goes on. 14

15 Conclusion The macro landscape appears to be deteriorating. With western Governments moving to reduce fiscal deficits as fast as possible, together with a consumer that remains burdened by high debt levels, we expect economic growth to slow down quite dramatically from here. The risk of a double dip recession in many countries is increasing. At the recent peak, equity markets were priced for perfection, and a brewing sovereign debt crisis is hardly the definition of perfection in financial markets. However, even after the recent 15% correction in markets, we believe that investors have not yet adjusted to the low growth environment in which earnings are set to disappoint and valuations become less attractive. Equity markets were overvalued, over loved and over owned at the peak in April, and it takes time for these measures to reach an undervaluation that would make markets attractive again. In the meantime, the trend appears to be turning from bull to bear and we have positioned client portfolios accordingly. In this more troubled environment, we have allocated some money to core Government bond markets and very selectively to some commodity exposure. We also continue to believe that for Sterling based investor s, currency strategies will add value in the months ahead. 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. 15