Fund Management Diary Meeting held on 16 th October 2018 Euro-zone competitiveness imbalances In the run up to the global financial crisis differing competitiveness levels across the euro-zone contributed to large current account surpluses in some countries and large deficits in others Germany could help to reduce imbalances and support the economic sustainability of the eurozone as a whole by reducing its current account surplus, but shows few signs of doing so Despite recent improvements, regional trade imbalances are likely to create stresses again in the euro-zone over the next several years Large current account deficits plagued the euro-zone periphery in the run-up to the crisis Even before the euro-zone was formed in 1999, unit wage costs, often viewed as a broad measure of (international) price competitiveness 1, were growing faster in the periphery than in Germany. This helps to explain why peripheral countries, such as Greece and Spain, ran persistent current account deficits. Nevertheless, at that time, the presence of national currencies meant that nominal exchange rates were at least able to adjust and act as a safety valve for countries where deficits became unsustainable. The introduction of the euro removed euro-zone investors risk from currency depreciation when investing in other euro-zone members. This contributed to a drop in country-specific risk premia and interest rates in peripheral countries, creating an increased appetite for cross-border investment and borrowing. Rather than funding productivity-enhancing investment, the resulting large inflows of foreign capital to the eurozone periphery were mainly used to finance consumer and housing booms. This contributed to a further pick up in the growth of wages and unit labour costs in these countries, prompting competitiveness to deteriorate. During the run-up to the euro-zone crisis, the region s imbalances manifested themselves in large current account surpluses and deficits. When they peaked in 2008/2009, the worst offenders, Greece and Portugal, had deficits of over ten per cent of gross domestic product compared to surpluses of five per cent in the Netherlands and Germany. The initial shrinking of the peripheral countries current account deficits was a cyclical phenomenon, driven by the sharp fall in imports that occurred as those countries fell into deep recessions and unemployment soared. Exports fell too, as world trade contracted, but to a lesser extent. These deficits have now almost completely disappeared. Portugal, Ireland, Spain and Italy are now running current account surpluses. Greece still has a deficit, but it is a small one at just one per cent of gross domestic product. Among euro-zone countries Germany still runs the biggest current account surplus in absolute terms and one of the biggest as a share of gross domestic product. In fact, the German surplus has grown since the financial crisis and represented about eight per cent of gross domestic product in the first half of this year, 1 Unit wage cost can be defined as the average cost of labour per unit of output produced.
well in excess of the European Commission s six per cent limit. 2 In contrast to the position a decade ago, Germany s current account surplus is at least now primarily with non-euro countries and appears to be more of an issue for global demand than it is for the sustainability of the euro-zone recovery. Nevertheless, the balance may well rise again if increasing domestic demand in the periphery prompts import growth to accelerate. The sustainability of euro-zone growth and stability depends in large part on whether crucial structural problems such as the existence of big regional trade imbalances have been resolved. Deficits in peripheral countries have disappeared but are likely to re-emerge There are some reasons to be hopeful that recent improvements in regional trade imbalances are permanent. Imports have bounced back but crucially, not as quickly as exports. In Spain, Italy and Portugal, the falls in their current account deficits since 2008 have been driven almost entirely by a rise in exports. Moreover, Italy aside, competitiveness has improved substantially due to internal devaluations as a result of economic reforms, providing encouraging signs that the shift has turned into a structural one, at least in some countries. For instance, since their peak after the crisis, unit labour costs have fallen by between six and eight per cent in Greece, Spain and Portugal. However, there are also reasons to be concerned and believe deficits of the peripheral euro-zone countries might come back. First, the improvement in competitiveness in the peripheral countries relative to Germany has not been enough to reverse the deterioration seen in the run-up to the euro-zone crisis. Although Germany is ultra-competitive and perhaps an unfair comparison, most peripheral countries have also closed only some of the competitiveness gap with France. Second, even the improvement in competitiveness that has been seen might be unwound as the peripheral economies strengthen further, as it has generally been driven by weak wage growth (rather than stronger productivity growth). Although weak wage growth might be a permanent response to structural labour market reforms, unemployment in most peripherals is above estimates of its natural rate, suggesting that the squeeze on wage growth has been at least partly cyclical. Third, there are few signs of any pick-up in underlying productivity growth that could deliver a lasting boost to competitiveness. With the exception of Spain, investment a key driver of productivity remains weak. And the current economic recovery could take the pressure off governments to reform. And fourth, even if the peripherals have been doing their bit to reduce imbalances, Germany has not been. Admittedly, it might yet take several years for significant imbalances to re-emerge. Factors such as high debt levels are likely to keep a lid on domestic demand in the peripherals for a while. It will also take time for labour markets to tighten further and feed through to faster wage growth and a renewed deterioration in competitiveness. Global monetary policy tightening could reduce the amount of money sloshing around the global economy, while tighter regulation of the financial sector and greater use of macro prudential policies could brake capital flows into the euro-zone. Germany s large surplus is not likely to be significantly narrowed anytime soon It is true that there is little that Germany can do about some of the causes of its surplus, namely an exchange rate which is too weak for it and an ageing population which has encouraged household saving. 2 Beyond that point, the European Commission judges a country to be experiencing imbalances, and can recommend policy action to bring the surplus down.
Nevertheless, this doesn t mean that there is nothing it can do. Stimulating consumption and investment in Germany could boost inflation, which would help deficit countries close the competitiveness gap. A lower German current account surplus would lower the euro-zone s overall current account surplus, staving off upward pressure on the euro and raising peripheral countries competitiveness outside of the euro-zone. Theoretically there are several ways for Germany to boost the economy and inflation. First, the German government could itself spend more money, on infrastructure for instance, increasing the economy s growth potential. Second, the government could introduce policies to increase private investment and productivity; as the surpluses are driven by successful exporters not investing their profits at home. Finally, it could introduce policies to encourage wage gains that would support household spending. The government could tackle the country s system of collective wage bargaining, preventing wage growth from responding to a tighter labour market or higher profits, and raise the level of public sector wages with knock-on effects to the private sector. However, the euro-zone s largest economy has done nothing yet to address the root causes of its persistent current account surplus, instead continuing to defy calls to inflate its economy. Even under the new coalition s proposals for looser fiscal plans, there are no policies on the cards to encourage private investment or bigger wage gains. And the fiscal easing is so modest that Germany s public debt would continue to decline. Capital Economics thinks that Germany s current account surplus will narrow due to the planned modest fiscal stimulus and slowing export growth over the coming year. However, they still expect it to be about seven per cent of gross domestic product in 2020. The euro-zone s trade imbalances are not likely to disappear anytime soon. *This diary has been written in conjunction with Capital Economics. Strategy In our Investment Committee meetings, Margetts have been discussing for quite some time that imbalances in the Eurozone are an issue, as it is not sustainable for countries like Germany to continue to run large trade surpluses with the peripheral Eurozone nations. This continues to be an area of political risk, and has contributed to the rise of populist parties in countries like Italy, which has not benefited from joining the Eurozone as much as Germany did. These risks are the reason why the Margetts Risk Rated portfolios continue to maintain an underweight or neutral exposure to European equities.
Fund Comments The below charts show the current positions of the fund, the tactical (short term) targets, and the strategic (long term) targets of the fund. We aim to keep the current positions in line with the tactical targets from week to week. The differences between the tactical and strategic targets reflect the views and convictions of the Margetts Investment Committee. Providence 60.0% 50.0% 40.0% 30.0% 20.0% 10.0% 0.0% Bonds Cash UK Europe ex UK North American Asia Pacific ex Japan Emerging Markets Japanese Global Current Position Tactical Targets Strategic Targets Asset Allocation: The above chart, as of 12/10/2018, demonstrates the fund s current asset allocation and the tactical targets set by the committee. No changes are being made to the tactical targets and we have made sells from the bond funds and topped up positions in the UK Equity funds in order to rebalance the portfolio following the market falls of recent days. Fund Selection: The bond holdings with a bias towards short duration bonds have continued to outperform their IA sectors over recent weeks, following the large rises in bond yields. The Royal London Global Index Linked fund has not performed as well due to its longer duration positioning, but this fund acts as a diversifier in the portfolio. With the exception of the Threadneedle UK Equity Income fund, most of the UK equity funds have performed well relative to the peer group over the market falls over recent weeks. We currently have no concerns with any fund holdings.
Select 50.0% 45.0% 40.0% 35.0% 30.0% 25.0% 20.0% 15.0% 10.0% 5.0% 0.0% Bonds Cash UK Europe ex UK North American Asia Pacific ex Japan Emerging Markets Japanese Global Current Position Tactical Targets Strategic Targets Asset Allocation: The above chart, as of 12/10/2018, demonstrates the fund s current asset allocation and the tactical targets set by the committee. No changes are being made to the tactical targets and we have made sells from the bond funds and topped up positions in Asian and Emerging Markets equity funds in order to rebalance the portfolio following the market falls of recent days. Fund Selection: The F&C European Growth & Income fund has continued to underperform the sector, however this has been partly offset by the Invesco Perpetual European Equity Income fund which has outperformed its peer group over recent months. We continue to monitor the F&C fund closely. The SVM UK Growth fund has lagged the IA sector in recent months, however this is likely to be due to its bias towards Growth stocks. This funds acts as a diversifier to the more Value orientated Jupiter UK Special Situations fund, which has outperformed the sector over the same period.
International 60.0% 50.0% 40.0% 30.0% 20.0% 10.0% 0.0% Bonds Cash UK Europe ex UK North American Asia Pacific ex Japan Emerging Markets Japanese Global Current Position Tactical Targets Strategic Targets Asset Allocation: The above chart, as of 12/10/2018, demonstrates the fund s current asset allocation and the tactical targets set by the committee. No changes are being made to the tactical targets or current allocations this week. Fund Selection: The Baillie Gifford Pacific fund has lagged the IA sector in the recent market falls, as Chinese and Tech stocks were quite badly hit. However, the L&G Asian Income fund continues to work well with this fund due to its more Value and Income tilt, and underweight to China. The Threadneedle Global Emerging Markets Equity fund has performed relatively poorly in recent months, and will be monitored closely going forward.
Venture 40.0% 35.0% 30.0% 25.0% 20.0% 15.0% 10.0% 5.0% 0.0% Bonds Cash UK Europe ex UK North American Asia Pacific ex Japan Emerging Markets Japanese Global Current Position Tactical Targets Strategic Targets Asset Allocation: The above chart, as of 12/10/2018, demonstrates the fund s current asset allocation and the tactical targets set by the committee. No changes are being made to the tactical targets or current allocations this week. Fund Selection: Over the past 4 weeks, the funds with an Australian bias have outperformed the other Asia Pacific ex Japan funds. Within the Emerging Markets selection, the Value orientated JPM Emerging Markets Income fund has outperformed the IA sector, whilst the more Growth orientated Threadneedle and Fidelity Emerging Markets funds have lagged the sector. The F&C European Growth & Income fund has continued to underperform the sector, however we continue to monitor the F&C fund closely and will see how it performs once markets volatility calms down.
Important Information Please note that the contents are based on the author s opinion and are not intended as investment advice. This information is aimed at professional advisers and should not be relied upon by any other persons. Any research is for information only, does not constitute financial advice or necessarily reflect the views of the author and is subject to change. It remains the responsibility of the financial adviser to verify the accuracy of the information and assess whether the fund is suitable and appropriate for their customer. Past performance is not a reliable indicator of future performance. The value of investments and the income derived from them can fall as well as rise and investors may get back less than they invested. Important information about the funds can be found in the Supplementary Information Document and NURS-KII Document which are available on our website or on request. Issued by Margetts Fund Management Ltd Margetts Fund Management Limited is authorised and regulated by the Financial Conduct Authority For any information about the company or for a copy of the company's Terms of Business, please contact the company on 0121 236 2380 or at 1 Sovereign Court, Graham Street, Birmingham B1 3JR You can e-mail us at admin@margetts.com