Thursday, 3 April 2014

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Friday, 21 March 2014

We’re not kidding – a mature, thoughtful budget… strictly for grown ups

Maybe, just maybe, the Government has recognised that a small carrot with a big stick does not work.

With an ageing and longer-living population, the cost of providing retirement benefits is ever increasing and a huge burden for generations to come. The public purse cannot afford to uniquely provide for all its citizens old age. Equally, it will not encourage saving, if there are too many restrictions on the benefits.

Could it therefore be that the much-maligned and ever chastised pension is the new Prodigal Son, returning from its wilderness, with errant features corrected?
Following the previously announced tinkering with contribution levels and limits, we now appear to have some genuine stability and attraction.

After today’s Budget you can be confident of receiving fair income tax relief on a reasonable contribution level and mop up years that you have missed. Have your growth largely capital gains tax free and invest and retire with wise advice. Aspire to achieve a £1.25m pot, though not a penny more. Fund your new ISA to £15k per annum, and any surplus in other tax-efficient structures like offshore bonds. VCTs and EIS remain too if you’d like some risk! Play fair.

When you’re getting on and looking to take benefits and if you’ve built up a fair sum, you can have confidence and take a quarter of your fund tax-free. Then take income and capital from the balance while paying some tax.  But make it last and don’t go crying to the Exchequer if it runs out. Remember you’re a grown-up now – that is the other thread running through the speech – the nanny state is being withdrawn.

When you decide to pop off, because the Treasury won’t want your spouse or heirs coming with their begging bowl, a fair tax at your marginal rate will be applied and funds can then be transferred. Gone has the automatic gift to charity, 83% or 55% taxes. It’s all common sense and simplification. Blimey.

Is it time to send the annuity to the knacker’s yard? Not yet. Smaller pots, and those with poorer health may still be best advised to buy an income for life. But nice to have the choice.

All very grown up wouldn’t you say?

Simon Blowey
Divisional Director of Financial Planning

Thursday, 20 March 2014

The budget for savers and investors

David Nicol CEO, Stephen Ford Head of Investment Management and many Brewin Dolphin analysts welcome the rolling back of the nanny state and the freedom for savers following the 2014 Budget.  

David Nicol, Chief Executive said "Today’s budget has unleashed a raft of measures that will be hugely welcomed by our industry and our clients. We have long campaigned against the iniquities of the annuity market and so we are delighted to see savers freed from those restrictions and that pensions have been underpinned as a key plank of the nations’ savings.

The reforms announced will allow us to go forward with certainty and advise our clients that pensions are no longer seen as an easy target for stealth taxes.  We look forward to working with the Treasury and the industry to see how the ‘right to advice’ can be delivered.

The increased ISA allowance and the new flexibility for ISAs is significant, too, for our clients and the industry – we have nearly £5 billion in ISAs out of our £28 billion FUM – and this figure will likely increase again next year. This is a welcome commitment from the Government that ISAs, too, are a core long-term savings vehicle for UK citizens and the news that peer-to-peer lending and other investments will be permitted, will enhance their attraction and their potential.

The doubling of capital allowances to £500,000 is most welcome to Brewin Dolphin, at a time when we are expanding our business and our office base."

Most welcome roll back of the nanny state and savers set free

“Like a phoenix from the flames, Osborne’s policy sees the British pension rise from its deathbed, freed from fears over stealth taxes and over complication. This is a total game changer, and will result in the almost immediate death of the annuity – for which we have long called for. It is a huge change in the flexibility of the pension system, with lower taxes and higher lump sums. We welcome the fact that the government is willing to trust people with their own finances and await clarification on how the vast amount of necessary advice will be delivered.”  - Stephen Ford, Head of Investment Management at Brewin Dolphin

But how did the market react?
The Life Insurance sector is down since the budget speech today after George Osborne said that the government would remove tax restrictions on how pensioners access their pensions, thereby effectively scrapping the requirement for retirees to buy individual annuities.

This is clearly bad news for life insurers who have annuities businesses including Legal & General, Resolution, Aviva and Standard Life and Prudential. However, this is mitigated by several factors. Investors had already expected the individual annuity market to be difficult in 2014 (due to low interest rates which makes these products relatively unattractive). L&G (and others) were already redeploying capital to more attractive areas.

The rules will not destroy the annuity market as many individuals are still likely to buy annuities to provide a predictable income for their retirement, in our view. In addition, they should still be able to benefit from the legislation by picking up some of the new business created though other savings and investment products (in particular via the growing investment management and platform businesses). -  Ruairidh Finlayson, Equity Analyst

“The Chancellor has removed the nanny knows best aspect of the ISA – allowing a far broader range of products, and the ability to switch from shares to cash and back again. With a massive increase in the amount that can be sheltered in an ISA wrapper, as well as the inclusion of peer to peer lending and shorter dated retail bonds, the ISA is now a far sharper tool in the tax planning toolkit.” - Stephen Ford, Head of Investment Management at Brewin Dolphin 

DOTAS schemes 
 “The taxman used to operate on the basis that taxpayers were innocent until proven guilty, but now it is the other way round. This new adverse cashflow may mean that Clients who wish to invest in government supported schemes may now think twice and beware.” – Simon Blowey, Divisional Director of Financial Planning at Brewin Dolphin 

EIS and VCTs 
“EIS and VCT tweak is significant - as the majority have income streams from Government backed renewable energy subsidies - which will no longer be allowed from April 6th within a VCT or EIS structure - which previously gave a 30% income tax relief to the investor.

HMRC have also fired an opening salvo against limited life structures - which offer investors maximisation of relief and an exit strategy over the underlying investment benefits”. – Simon Blowey, Divisional Director of Financial Planning at Brewin Dolphin 

Impact to betting agencies
“The betting agencies reacted badly to Osborne’s budget, for good reason. The announcement that the fixed odd betting terminals (FOBT) duty would be raised from 20% to 25% shocked the market. William Hill (£180m off its market cap so far) and Ladbrokes (down 10% and falling), both pay around £90m gaming duty so this could add another £20m to their respective tax bills. All other things being equal, this will lead to large consensus downgrades, mainly for Ladbrokes which is the most exposed to FOBT revenue as a percentage of group.

There are more than 33,000 fixed-odds betting terminals in the UK according to the Gambling Commission which goes on to explain that the average weekly profit per fixed odds betting terminals in 2012 was £825, up from £760 in 2011. The gross profit from the FOBTs in 2012 was around £1.4bn.

The number of betting shops in the UK increased from 8,862 in 2009 to 9,031 in 2013. The big three operators had plans to open hundreds of new shops although many independent operators have closed. This tax could change the profitability of many shops on a case by case basis and therefore could lead to further closures. Government has also not ruled out further changes so companies will have to make amendments. Add to this the forthcoming introduction of a Point of Consumption tax in December and the betting agencies are having a tough time!”  - Ed Salvesen, Deputy Head of Equity Research at Brewin Dolphin

Frozen carbon floor
In-line with our expectations the Chancellor announced the carbon price floor will be frozen at the 2015/16 level of £18.08/t until the end of decade.

This is clearly good news for energy consumers and energy intensive industries as it will mean electricity prices will be lower than would have otherwise been the case until the end of the decade. It also improves the UK competitiveness compared to the rest of Europe, as the carbon floor tax simply increased the cost of carbon emissions in the UK over and above the EU carbon tax.

The electricity generation sector will be one of the sectors most directly affected by the change in policy. Higher carbon producing generators will see their costs reduce. Counter to this, renewable generators will be negatively impacted by this announcement.

As one of the largest coal plants in Europe, Drax, will be one of the biggest beneficiaries and with all other factors being equal we believe it could improve EBIT between 3%-5% in 2016/17. Drax’s share price has reacted positively to the news and is up 0.82% today to 794.5 (at the time of writing). – Elaine Coverley, Head of Equity Research at Brewin Dolphin

Housebuilders and Help to Buy
The Chancellor has announced that he will be extending the Help-to-Buy scheme for new-built homes until 2020. This has ended speculation that the scheme would be wound down earlier than expected.

The extension only applies to the first phase of the scheme (Help-to-Buy 1 or H2B1), which is the equity loan scheme, and not the more controversial larger mortgage guarantee scheme (Help-to-Buy 2 or HTB2). The Chancellor says that the additional £6bn of government funding would help to finance the building of 120,000 houses by the end of the decade.

The news has provided a fillip for the housebuilders which have seen their shares come back sharply recently. The extension should provide some impetus for housebuilders to build more homes outside the currently-favoured South East. Hence we believe that the main beneficiaries will be those companies with a national presence, such as Persimmon, Taylor Wimpey and Bovis Homes, rather than those with a South East bias.

What is also required to increase the number of new houses to the required level is for smaller, unquoted housebuilders to return to the market. They have, to date, been frozen out by the absence of finance from the banks.

By increasing the bank finance available to smaller housebuilders, volumes would start to increase. Competition for land would increase, labour rates would continue to accelerate and there could be a supply shortage of building materials. In short, there would be a detrimental impact on margins. We shall not be changing our stance on the housebuilding sector but believe that builders' merchants such as Travis Perkins is a better way for investors to take advantage of this Budget news. - Stephen Williams, Equity Analyst 

Wednesday, 12 March 2014

The budget – will they fudge it?

As the 19 March budget looms, the fickle nature of the pensions industry will likely be high on the agenda – with increasing demand for reform in the annuity market.

“Over recent years we have seen a constant nibbling away at the incentives to save,” says Brewin Dolphin’s head of financial planning, Nick Fitzgerald. “A commitment from the government that pension reliefs will not be tinkered with for the lifetime of the next Parliament would help restore trust.”

That wish is endorsed by many facing retirement, but it’s in no way assured. Unperturbed, our crack team of seers are happy to voice predictions and air their rationale in key areas:

Richard Harwood, divisional director financial planning - predicts:

  • Restrictions on some of the more esoteric investments that can be held in pension schemes.
  • Possible new limits to pension tax relief that may hit the ‘squeezed middle’
  • Announcement that small pension pots – say <£40k – will no longer be forced to buy an annuity

“The government has put in place measures to further limit tax reliefs to those thought of as wealthy. It would seem that there is political will to restrict tax reliefs so the limits may be tightened further in future, but there is a danger that these will again hit the ‘squeezed middle’”.

Tax & NI
Guy Foster, head of portfolio strategy - predicts:

  • A rise in the national minimum wage beyond the 3% recommended by the low pay commission – which may hamper further advances in the personal allowance.
  • The distinction between income tax and NI to be made clearer.

“Mr Osborne has been quite clear about the type of budget he is planning. Large scale giveaways aren't justified by either the political or economic cycle this year.  Even as inflation falls, however, the accumulated decline in real incomes from rising prices and stubbornly inert wages remains a hindrance to economic prospects.  A big issue, therefore, is what he may do for the low paid.”

Richard Harwood, divisional director financial planning - predicts:

  • Possible increase in investment limits for Venture Capital Trusts and Enterprise Investment Schemes.
  • Further tweaking of the rules to ensure that eligible investments are not just tax-relief schemes.

“Increasingly EISs and VCTs are providing funding for businesses that would traditionally be the domain of banks.  But we would not be surprised if there was further tweaking of the rules on what investments are approved in order to ensure that there is true risk within the plans and that they are not just schemes to maximise tax reliefs.”

Tax avoidance
Richard Harwood, divisional director financial planning – predicts:

  • The closure of perceived tax avoidance loopholes to be highlighted.

“This continues to be a priority and any victory in court for HMRC is strongly publicised.”

Rob Burgeman, divisional director – predicts:

  • A potential commitment from the Government to ISAs as a core long-term savings vehicle for UK citizens.  

“Speculation is building that there may be changes here and the uncertainty is most unwelcome and destabilising at a time when every encouragement should be given to those seeking to ensure their long term financial security. Any restrictions on ISA savings will drive the spare savings flow into the already overheated property market.”

Capital gains tax reform
Rob Burgeman, divisional director predicts:

  • Greater simplification to emerge over CGT.

“As savers are now being taxed on inflation since the indexation of book costs was removed, how long will it be before we see fair differentiation in the taxation of short-term speculation and long-term investment?”

Wednesday, 5 March 2014

Give yourself a break: 5 ways to help get in tiptop tax shape by 5 April

When making your savings and investments work hard, it’s just as important to make the most of your tax reliefs as it is to chase the best interest rates and portfolio returns.

ISAs are just one example of the ‘low effort’ strategies that people can implement every year which, over time, may greatly enhance their savings. But with the end of the tax year approaching rapidly, you should be aware of other simple actions that could prove valuable.

Consider these key ways to make the most of tax reliefs before 5 April – the benefits of which may last a lifetime.

1) Use your ISA allowance

  • Those aged 18 and over can invest up to £11,520 each
  • Parents can also fund Junior ISAs up to £3,720 each (which equate to a total of £34,200 for a family of five)
  • Remember that income and capital gains from ISAs are tax free, so consider using the allowance for your risk based investments rather than your cash 

2) Consider possible pension contributions

  • The pension Lifetime Allowance (LTA) reduces to £1.25m on the first day of the new tax year (6 April), so check your pension benefits before then. If you expect your pension fund to exceed the LTA when you retire, consider applying for ‘Fixed Protection 2014’ – but beware as this might preclude you from further pension savings once you have applied for it. We strongly recommend seeking professional advice
  • The next tax year will also see the annual pension contribution which attracts tax relief at your marginal rate reduce to £40,000 gross. You should check this year and contribute the maximum amount if your UK relevant earnings allow it
  • You will receive 20% tax relief if you make a stakeholder contribution of up to £3,600 gross for your children or non-working spouse
  • For parents: if making a further pension payment brings your individual taxable income(s) below £50,000, you may be able to reclaim / retain child benefit (e.g. you would currently receive £2,449 p.a. in child benefits for three children of education age) 

3) Transfer assets

  • Transfer income producing assets to your spouse or civil partner if they are a lower rate tax payer. Calculate the income from the asset per £1 and transfer enough to use up the lower tax band. (e.g. Mrs X is a 40% taxpayer, Mr X is a 20% taxpayer, so transfer assets to Mr X)
  • The same can be done with regard to capital gains, which is charged at 28% for high rate taxpayers and 18% for basic rate. Transfer assets with gains to the lower rate taxpayer and use up both of your allowances, which stand at £10,900 each for the 2013/14 tax year
  • When it comes to inheritance tax, you can use your annual exemption allowances of £3,000 each for the 2013/14 tax year. If you didn’t use last year’s allowance you can add that, increasing the allowance to £6,000 each 

4) Offset losses to reduce your capital gains tax

  • Consider ‘realising’ a gain or loss to offset against your annual CGT allowance (£10,900)
  • Remember also that you can effectively increase your CGT allowance if you decide to sell one of your assets at a loss, since this can offset gains elsewhere
  • Note that excess losses can be carried forward, but normally have to be claimed within four years 

5) Seek advice on other forms of enhanced tax relief

For those with a higher risk appetite, an Enterprise Investment Scheme (EIS) or Venture Capital Trust (VCT) can offer some great tax incentives, but it is essential to seek advice before investing in this sort of scheme.

  • You can invest up to £1m into an EIS per tax year, although note that you must remain invested for a minimum of three years. For those with a medium term investment horizon, benefits include 30% income tax relief on the premium, deferral of capital gains tax and the ability to offset capital losses against your income tax bill
  • You can invest up to £200k per tax year into a VCT (minimum 5 years), the benefits of which include 30% income tax relief on the premium, and dividends that are free of income tax
  • Note that to receive the 30% tax relief you need to have paid at least the equivalent amount in income tax 

Please remember to seek professional advice as everyone’s individual circumstances are different. Our full tax guide for 2013/14 can be found here

Friday, 21 February 2014

Tobacco companies advertise on TV for the first time in decades

This week saw the return of TV advertising by the big tobacco companies after being absent from TV screens for two decades. The big tobacco companies have now entered the e-cigarettes market and are throwing their bank balances behind TV advertising campaigns. E-cigarettes are not covered by current UK legislation against tobacco advertising and fall between the regulatory gaps. As such tobacco companies, such as British American Tobacco, are taking advantage. On Monday evening BAT's e-cigarettes brand Vype was advertised, with the slogan “pure satisfaction”.

A consultation on UK advertising rules for e-cigarettes is expected later this year, and could be as early as next month. The rules for print, TV and online advertising are currently unclear. Traditional cigarette advertising has been banned from UK TV screens since the 1960s while loose tobacco and cigar advertising was banned in 1991.

In the US e-cigarettes have been around for longer and are more widely known to consumers. Demand was strong in 2013 driven by early adopters. We believe high demand growth will be harder to achieve in 2014 as the products are moving into the mainstream. Therefore advertising will be more important to increase consumer awareness. To date 20 million smokers have tried e-cigarettes, however, only 25% of consumers have made repeat purchases and switched from traditional cigarettes to e-cigarettes.  E-cigarettes sales peaked in August last year, we believe because early adopters were not satisfied with first generation products.

In the US e-cigarettes have been advertised on TV for a couple of years. Both the Blu brand and NJOY brand have been advertised during the Super Bowl, one of the most expensive advertising slots on US TV, costing around $133,000 a second. Anecdotal evidence would suggest advertising in the US has been successful as Blu and NJOY enjoyed a combined 70% market share in summer 2013. According to the 2014 American E-Cigarette Etiquette Survey two-thirds of Americans (63%) say they would not be bothered by someone using an e-cigarette in close proximity.

According to the British Medical Journal, UK advertising and promotional spending on related smoking materials, which includes e-cigarettes increased from £1.7m in 2010 to £13.1m in 2012. This increase is likely to continue as the tobacco industry gets more involved. In 2013, British American Tobacco spent £3.6m in just two months to promote Vype.

Four TV adverts have already been banned in the UK by the Advertising Standards Agency (ASA) for not clearly identifying the product, including E-Lites, SKYCIG (owned by Lorillard), V2 and Ten Motives. The E-Lites advert featured a dancing baby and V2 was banned for implying it could be used as a smoking cessation device.

Tobacco companies on both sides of the Atlantic anticipate much tighter advertising regulation, and will adapt or stop adverts as and when required. Until then they will continue to take advantage of the lack of regulation.

At the end of 2013 the e-cigarettes market accounted for 1% of the global cigarette industry, accounting for $3bn of sales compared to the global tobacco industry of $700bn. However expansion could be rapid and one day e-cigarettes could replace cigarettes entirely. No wonder the big tobacco companies are trying to muscle in on the act.

Elaine Coverley, Head of Equity Research

Friday, 7 February 2014

Before the tremors: six vital questions to ask your SIPP provider

Investors with popular Self Invested Personal Pensions (SIPPS) are being warned of a seismic shock to the industry, which could lead to many providers increasing fees, selling up or even stopping trading altogether – so what can you do to prepare?

The FCA is expected to produce new guidelines for SIPP providers in the early part of 2014 that will lead to providers having to raise extra funds or get out of the market.

Watch out for higher fees, and providers who stop providing
Individuals with SIPPs will need to ask tough questions of their SIPP providers to find out whether they are about to be hit with a fee increase or face the prospect of a provider going out of business.

SIPP providers who have allowed non-standard assets, which include commercial property, into SIPPs are likely to be hardest hit – with the Financial Conduct Authority’s proposed capital adequacy rules undoubtedly thinning down the SIPP provider market.

So if you want to stay in control of your pension and know that your provider is going to continue trading, you must ask these crucial questions:

  1. Is your SIPP provider financially strong and reserving for the newly proposed FCA capital adequacy rules?
    There is no list currently of who can or can’t pass the test. Most providers will have undertaken a calculation and will know if they are at risk. You should ask your provider directly.
  2. Is your SIPP provider making a profit and can demonstrate consistent profitability over a number of years?
  3. Who actually owns your SIPP provider? Is it a private individual(s) or a large body corporate?
  4. How many SIPPs does your SIPP provider administer and what percentage of these are invested in non-standard investments (this includes commercial property)?
  5. What are your SIPP costs relative to the market?
    Customers with relatively simple SIPPS should check that they are not paying for features that they are not using and subsidising other pension scheme members that are higher risk.
  6. Does your SIPP provider offer a full range of retirement options (such as flexible drawdown)?

Wednesday, 5 February 2014

Emerging Anxiety

'Be fearful when others are greedy, and be greedy when others are fearful' - Warren Buffet.

In the same vein as a newly elected politician, the latest iteration of central bank policy, or even a One Direction album, I have often found that financial articles disagreeing with the world's paramount investor, do not live up to their promise. In light of this observation, I would, instead, like to 'modify' the application of the Buffet thesis at this stage of the cycle for emerging markets. As I will go on to explain, such is the dependence on foreign capital for many quarters of the developing world that we should, rather, be 'fearful when others are fearful'.

JPM Emerging Market Currency Benchmark*

Given the deteriorating fundamentals, as well as unattractive valuations, one of the last pillars of support for this asset class is global capital. It is often proposed that, despite the associated increase in price volatility, the high (if waning) growth levels should win out in the long run, and help deliver superior returns. But could it be, however, that this last bastion of support is starting to crumble? According to EPFR data last week it might just be - during which we witnessed the largest outflow of funds from Emerging Market equities for over 2 years.

The negative sentiment toward the Emerging World has been heightened of late, with markets becoming even more certain of the course for US monetary policy. In its first unanimous vote since June 2011, the Fed agreed to cut the level of asset repurchases by $10bn for the month; this despite a very disappointing employment report. The consequence of this, and the read by markets, is that unless we get some persistently weak US data, the Fed will not deviate for its intended path of removing emergency stimulus (QE). This will 'likely' stir a gradual rise in bond yields, sending the cost of capital higher across the globe.

This outcome would prove particularly painful for the so-called ‘Fragile Five’ - Brazil, Turkey, India, Indonesia and South Africa - who run persistent current account deficits (import more than export) and, therefore, are dependant on additional external funding. Taking a closer look, the situation for both Turkey and South Africa, who have acquired large amounts of foreign denominated debt, is even more acute. For an economy to find its equilibrium, imports should roughly equal exports, and to achieve this 'current account deficit' countries should allow their currencies to weaken. This would inflate the cost of imports and encourage domestic substitution, as well as boosting exports. Not only does this generate higher levels of inflation however (cue civil unrest), it also makes the servicing of US$ denominated increasingly challenging. In order to defend their respective currencies, the South African and Turkish central banks have both enacted emergency, large scale, interest rate rises. It was hoped the increased yield on offer will stall capital flight. Relief proved only temporary, however, as markets looked through the noise and focused on the negative connotations of higher borrowing costs on domestic growth.
Further to this, and one of the more alarming coincidences, is that every one of the Fragile Five faces a general election this year. Admittedly there is hope these elections may bring reform but, more likely, they will usher in yet more socialist policies from unpopular incumbent governments. These types of policies could bring yet more revolt from international investors.

If we combine these issues with the increased scrutiny of the Chinese shadow banking system, in which souring loans are gaining increased attention from the markets, then the fear factor really starts to escalate.

Once again, best to sit this one out from the sidelines. Bargain hunting can wait; as is the case for One Direction albums: Up All Night is still holding on to £6.99 on iTunes!

*JPM Emerging Market Currency Benchmark: Nominal performance of EM currencies versus $US

Ben Gutteridge
Head of Fund Research

Monday, 27 January 2014

The ogre of deflation – should we be scared?

Christine Lagarde, the Managing Director of the IMF said earlier this week that the ogre of deflation has not yet been slain.  By deflation, of course, she meant a general decline in prices.  Falling prices may not sound too bad – instinctively it sounds quite good, so why does deflation take the form of an ogre which haunts the nightmares of Christine Lagarde?

In simplistic terms, companies make lump sum investments and then receive a growing stream of income from those investments. If the stream of income is shrinking, because prices are falling, that makes the investment less attractive. That's not a good environment for investing in company shares.

So do we prefer inflation?  Not really. The truth is that too much of anything can be bad for you.  Too much inflation and interest rates and investors will find attractive returns away from the equity market.  Too much deflation and equity returns will be poor as company profits will stop rising.

What does that mean for me?
Falling inflation is positive for investors because monetary policy can remain loose – by that we mean interest rates will stay low making equities and bonds attractive.  Ultimately, high interest rates tend to be poison for a bull equity market – usually within a year or so. Low inflation makes higher interest rates an unlikely proposition.

For savers, low inflation is better news but, even with the recent fall, a savings pot earning the Bank of England base rate would be able to by less goods every year due to the effects of inflation.  Outright deflation would change that, but there is little evidence that the current fall in prices represents the start of a general price fall in the UK.  Rather it seems to be the rolling off of the tax hikes implemented as part of the austerity drive of recent years as show by the graph below which shows the normal rate of consumer price changes and what they would have been had taxes been kept constant.

The ogres of deflation and inflation appear equally tame for now.

Guy Foster
Head of Portfolio Strategy

Friday, 24 January 2014

What falling steel production growth says about Chinese GDP

Chinese power demand is a closely watched lead indicator due to its correlation with Chinese GDP growth. Less known is the high correlation between steel and power production in China. This relationship is not only statistical but also causative. Steel production directly uses around 15% of power in China and all industrial metals (including aluminium, copper and zinc) use around 30%.

Since some steel production data is reported before power and GDP data, this can provide some insight, and right now falling steel production growth is causing us to worry about first quarter GDP growth. Steel production growth fell from 7.5% for 2013 to 6.5% year-on-year in December, according to the National Bureau of Statistics (interestingly power demand growth also weakened from 7.5% in 2013 to 5.9% year-on-year in December). CISA (the China Iron and Steel Association) reported that production growth for the first 10 days of January fell further, to 2.7% year-on-year.

What does this mean for GDP growth? The Chinese power intensity of growth (the ratio of power demand growth to reported GDP growth) has fallen from 1.3x in the decade to 2008 to around 1x since. Steel intensity of growth has also fallen from around 1.5x pre 2009 to an average of 0.6 since (see the chart below).

A 2.7% steel production growth rate could imply Chinese GDP growth of around 4.5%. We view this as a highly unlikely scenario - steel production can be volatile and change significantly from week to week. However, the steel production trend in December and early January does make the first quarter consensus forecast, which is currently 7.60%, look on the high side.

Nik Stanojevic CFA
Divisional Director

Friday, 17 January 2014

Vodafone: Could the third largest FTSE stock disappear from the UK?

Vodafone, the company that bid for the first UK mobile licence in 1982, and bought Mannesmann in 2000, the then largest ever corporate merger valued at £112bn, could be bought by US or Japanese interests after it distributes the proceeds of the Verizon Wireless disposal.

Vodafone plans to distribute almost half its value via a special dividend on 24th February following the divestment of the 45% stake in Verizon Wireless, its US mobile asset. At current prices just over two thirds of the distribution will be in Verizon Communications shares with the rest in cash.

AT&T could be preparing to bid for Vodafone after the distribution (it is not possible before this due to antitrust). AT&T has made no secret of its international ambitions and has the balance sheet to support a bid, which would certainly also contain a large share component. A highly profitable US wireless market means that telecoms shares are trading at a premium to European listed companies. AT&T may choose to use its own highly rated shares as an acquisition currency.

Vodafone shareholders now have double exposure to the US wireless market, directly through Verizon shares and indirectly through AT&T, where the potential for a bid is partially baked in. We have for some time believed that this market is likely to get more competitive with the entrance of T-Mobile USA as a credible number three national operator in mid 2013. T-Mobile USA has been gaining share but so far growth rates for the incumbent players have also held up. AT&T may just be able to get a deal done before the US market turns and its deal currency is de-rated.

What will Vodafone shareholders get at current prices?
At current prices and FX rates*, a Vodafone shareholder who owns 1000 shares will receive a cash distribution of £300, and £756 in Verizon shares (25 shares). Vodafone is planning a share consolidation on the 24th February, after which investors will own 560 Vodafone new shares paying a dividend of 11p per share, which equates to a total dividend of £62 on the holding. This yields 4.6% at the current Vodafone share price.

What should shareholders buy with the proceeds?
For shareholders who don’t want to own Verizon, or in the event that Vodafone is bought, the obvious choice and the only remaining large cap listed UK telecoms share is BT Group. While this has a compelling growth story, its significant out-performance means that there may be better opportunities elsewhere. Europe offers a wide choice of M&A and restructuring stories. Netherlands incumbent KPN could benefit from de-leveraging after the sale of its German mobile asset, turnaround in its domestic business and potentially an eventual takeover by Carlos Slim’s America Movil, which walked away from a bid in October last year. Portugal Telecom (PT) could benefit from Brazilian mobile market consolidation and from a cleaner corporate structure. Telecom Italia (TI) could outperform if it sells its Brazilian mobile business (TIM Brazil) for a good price and uses the proceeds to turn around its domestic business, although risks remain high for both PT and TI.

* Vodafone share price of 240.0p, Verizon share price of $48.10, US$/GBP exchange rate of 1.643.

Nik Stanojevic CFA
Divisional Director

Thursday, 16 January 2014

Shale gas – It is not as important as politicians would have you believe

The US shale industry has enabled a renaissance in US industrial production. The Prime Minister and Chancellor are hoping that a UK shale boom can create the same dramatic benefits for the UK economy.

Despite the Coalition Government’s growing affection for shale gas, we believe it is unlikely to fix the UK’s looming energy crisis, or provide any significant contribution to gas production this decade. The chancellor, George Osborne, believes that shale gas has “huge potential” to provide employment, help diversify the UK’s energy mix, and reduce energy bills. The shale boom in the US has resulted in significantly lower gas prices, which in turn has helped boost the country’s recovery and resulted in a re-shoring of industrial production. US natural gas prices are about one third lower than those in Europe.

The US has a number of advantages over the UK when it comes to shale gas exploration such as the mineral rights, a history of on shore drilling, and less stringent environmental standards.

However, the fact that the UK is coming later to the shale gas party could be a benefit. Advances in fracking technology could mean that the UK is potentially able to take advantage of lower cost pad drilling at an early stage in the development of the industry.

We estimate that breakeven rates for shale in the UK could be $90/bbl (on an oil equivalent basis) compared to $70/bbl for US shale. However the higher gas price in the UK means exploration companies could achieve better margins even at higher breakeven rates. The offset to this is obviously the fact that commercial volumes are likely to be significantly lower in the UK than in the US.

Last year, the British Geological Survey reported that the Bowland shale, which covers 11 counties in the North and Midlands, could contain up to 1,300tn cubic feet of gas. It is estimated that the UK has some of richest shale deposits in Europe, followed by Poland.

We believe the shale industry is unlikely to produce commercial volumes of gas until the end of this decade and that it is unlikely to have a meaning full impact on gas prices. This is due to two reasons, firstly commercially available volumes are likely to be significantly lower in the UK than in the US, and secondly if UK shale is successful, exploration companies could export the gas to achieve higher prices.

The tax breaks available for on-shore unconventional drilling compared to off-shore conventional North Sea gas mean the Government is already in effect subsiding on-shore shale. The current proposal is for a 30% tax, providing the exploration company uses the most efficient drilling method, which compares to a 65% tax for off-shore North Sea exploration.

The announcement this week from the Government that local authorities will be able to retain 100% of the rates collected from shale sites will help to reduce local resistance, but there remains significant opposition to on-shore drilling due to concerns about water pollution, increased traffic and earthquakes.

Source: Bloomberg

Perhaps politician’s time would be much better spent working out how the Government rather than consumers are going to pay for the 100GW of new generation capacity which would be required in the UK to meet the country’s current 2030 carbon reductions targets.

Elaine Coverley, Head of Equity Research 
and Iain Armstrong Oil and Gas Equity Analyst

Friday, 10 January 2014

The Internet of Things revolution is here

The Internet of Things revolution is upon us and that it is likely to affect all our lives, whether we are particularly aware of it or not. It will revolutionise consumer interaction with relatively docile devices such as washing machines and thermostats, as well as ‘enhance’ clothing through wearable tech, save lives through the use of smart implants and save energy with the use of ‘big data’ analytics.

There are varying definitions but the Internet of Things essentially encompasses any ‘smart’ device that is connected or connectable via a network, generally excluding ‘traditional’ mobile devices such as smartphones and tablets. Technology advisory firms have been giving wide-ranging estimates for the size of this market - around 30bn installed units by 2020 seems to be a rough consensus, compared to the 7bn mobile phones in use today.

Ahead of the Consumer Electronic Show (CES) this week in Las Vegas, we have been looking at the latest trends in mobile technology and the potential impact on the various companies exposed to the sector. Both Apple and Samsung have suffered of late on the back of poorer than expected mobile device profits and it looks to us that this trend is set to continue.

The inflexion point at the high-end of the mobile market is upon us and growth is now likely to come from the mid to low-end in emerging markets, resulting in continued volume growth but significantly lower incremental profits. On the consumer side, the Internet of Things is set to be the next big thing for chip makers. However, we do not think this will be quite as lucrative as the mobile device boom, in the near term at least.

Inventors are coming up with all sorts of ‘smart’ gadgets that may or may not help us in our everyday lives. Wearable tech, whether it be smartwatches or headphones in a headband, appears to be one of the biggest themes of CES. Household goods connectivity and ‘smart’ toys are also making a strong appearance. Whilst we see the benefit of a connected thermostat for consumer convenience, energy saving and ‘big data’ gathering that can help utility companies measure demand, we are not quite so sure that humanity will be saved by the invention of fridges that re-order your shopping automatically, although this could be useful.

The principle is that the chips necessary for a device to be connected become so small and cheap, that even if the benefit of the ‘thing’ being ‘smart’ or connected is relatively marginal, it may as well be connected. The benefit may not just be for the user. When data is gathered from all such devices and analysed, patterns can be identified and efficiencies or sales made. This of course brings up ever topical security and privacy issues.

The gathering of data is often regarded with suspicion by the public, particularly given recent revelations surrounding the US and other governments’ surveillance activities. Education and reassurance is one aspect required by companies. Another is a reasonably high level of sophistication at the chip level in order to combat hacking. ARM suggests chips need to be at least 32-bit in order to be successfully secured. These are available today but are more expensive than 8 or 16-bit.

The exact size of the opportunity in dollar terms for the chip companies, is unclear at this stage; however, we would suggest that this is not directly comparable to the start of the mobile device boom due to the significantly lower chip value necessary for the market’s success (below $1 compared to high-end mobile device chips of $20). On the other hand, the volume opportunity is much larger therefore this is not an insignificant opportunity either.

The issue for the chip designers and manufacturers is whether or not the IoT growth story will play out in time or be of the profit generating scale necessary to alleviate the fall off in mobile growth rates. Clearly with developed market smartphone saturation as high as it is (over 50% in developed markets), growth is likely to slow significantly at the high-end in particular and, whilst developing market growth rates are strong, smartphones being sold are generally at the mid to low-end of the smartphone price and component scale.

In addition, the IoT opportunity is most likely to be back-end loaded this decade and into the next, i.e. we are expecting the vast majority of the billions of devices to be installed from 2020 onwards rather than within the next couple of years. This potentially leaves a worrying ‘growth gap’ for the manufacturers and chip designers, unless the IoT revolution can ramp up much sooner than we expect.

It is too early to call the winners of IoT, in our opinion, as no current player has a comprehensive solution and a number of new companies will no doubt be created over the next decade to service this market. Watch this space.

Ruairidh Finlayson
Equity Analyst

Friday, 20 December 2013

Taper time...

All year the Federal Reserve has been buying $85bn of assets with newly "printed" funds. In May the Fed's chairman, Ben Bernanke, first shocked the market with the news that this unprecedented level of support would have to be withdrawn at some stage. He went on to say that the withdrawal would probably start this year and be completed by the middle of next year.

Despite this guidance, forecasters generally predicted the first "tapering" of asset purchases would occur in March - they had been chastened by the mistakenly predicting the first taper in September. But since then economic news has been strong. Payroll growth, in particular, has been running at close to 200,000 new jobs per month. Four weeks ago, therefore, we began talking about the prospects of asset purchases being  tapered in December in the seventh edition of the Brewin Dolphin podcast (available in our archive).

At the same time we observed that the market was beginning to react positively towards good economic news - an improvement on the conditions which had prevailed throughout much of the year when investors would cheer bad news and the enduring monetary stimulus it implies.

This week the Federal Reserve did indeed taper its rate of asset purchases by $10bn per month. The $10bn is comprised equally of Treasuries and mortgage backed securities (MBS) and leaves the Fed buying $40bn of treasuries and $35bn of MBS despite Fed research which shows that Treasury purchases provide little benefit to the economy.  So why isn't the Fed winding up Treasury purchases faster than MBS purchases? Because they are running out of MBS to buy.  Issuance has fallen following the rise in MBS yields after Bernanke first discussed tapering.  That said, Treasuries are in a similar position. The twelve month average budget deficit was $88bn at the start of this year. Now it has fallen to $51bn.  Falling issuance is just one factor supporting a wind up of these programs.

Contrary to the predictions of market collapse without the Fed's support, developed market equity investors have cheered the decision - the reaction has been more mixed in the emerging world.  Ben Bernanke guided the market to expect similar sized tapers at future meetings, creating an expectation that the quantitative easing will only end in October.  We would expect the Fed to start accelerating its tapering efforts by March.

Thursday, 12 December 2013

Top 9 Economic Predictions for 2014

Indexes to rise
In 2014 we expect the FTSE to reach 7,400; the S&P to hit 1,900; and the Nikkei to breach 18,000.

Equities become the asset class du jour
We see equities becoming the asset class du jour for investors. This is not built on a universal cyclical recovery, but rather by falling prices which we have been talking about all year. Policy makers and investors will come to recognise that extreme measures are required to combat deflation, and that in such circumstances the prospects for equities are extremely robust.

Inflationary pressure to remain weak throughout 2014  
Despite better economic news weak prices will prevail in peripheral Europe.  Spain and Greece will flirt with deflation throughout the year. Italy will see higher sales taxes holding price gains. Yet Germany however should see inflation driving towards 2%, as tighter labour markets and the prospect of the minimum wage mean consumption starts picking up.  Monetary policy will become easier  as the rise of extreme parties pushes non-core countries to insist that Europe’s one size monetary policy is made to fit all.

With the UK on the up, inflation likely to head down
We see UK GDP exceeding 3% in 2014. The revitalisation of the financial markets and corporate deal-making mean a recovery in service sector productivity.  Inflation here, too, is likely to trend downwards, touching 1.5% by the year end.

The Fed puts away its cheque book
The Federal Reserve will cease asset purchases next year given the strength of the recovery underway and the boost still to come from a recovery in construction and lower fuel bills. Positive real income growth mean the US could be raising interest rates at its October meeting.

US mid-term elections – who will feel the pain?
The US mid-term elections present an historic opportunity for President Obama to play out the remaining two years of his tenure with both houses of Congress in Democratic hands. Despite investor focus on the Republican’s disastrous handling of the US shutdown the chance for gains in the House is limited by the low number of tight contests.  Meanwhile, the President’s woeful implementation of the Affordable Care Act, while further from investors’ consciences, is front and centre for US voters and Democratic senators will feel the pain come November.  The sitting President’s party tends to suffer in the mid-terms and we suspect the houses of congress will be allied against the President not for him by the end of 2014.

Emerging markets will have their time – but this is not it
Rising transportation costs, deteriorating energy competitiveness and institutional weakness means the year end’s events in Thailand and the Ukraine will likely remain themes for the new year. Investors should focus on the more developed emerging markets where intellectual property rights are entrenched – markets like Korea should rebound well from their recent slowdown. October’s elections in Brazil will be a major source of uncertainty with the World Cup looking likely to prove a national embarrassment having already been perceived as a wasteful pit of vested interests by ordinary Brazilians.

Hope comes to India
Patience with India’s ruling Congress party looks to have been exhausted. May’s elections will also see a change of government there which should pave the way for market-friendly reforms.

Investors should capitalise on Japan’s extraordinary inflationary policies
The yen is falling to 120 to the dollar; whether it gets there in 2014 remains to be seen but we conservatively estimate that these extraordinary policies pursuing inflation remain potent forces of value creation for investors.

Guy Foster
Head of Portfolio Strategy

Thursday, 5 December 2013

UK energy policy – Why a price freeze won’t save consumers money in the long run

Listening to politicians about energy policy you would think carbon reduction targets are low down the list of priorities as the debate about affordability rages on. One minister went as far as to change the energy trilemma to an energy dilemma, stating that UK energy priorities are affordability and security of supply, carbon reduction was noticeably absent from the list.

For the past fifteen years, we have had a renewable policy but no energy policy, which has helped lead to the current problems. Our current carbon reduction targets for 2030 require the UK to build 100GW of new renewable power generation capacity. This is an enormous task, particularly as the public and capital markets are being asked to fund it. It also looks implausible at this stage, given the recent backlash we have seen against rising energy bills. To put this target into context the dash for gas the UK entered into in the 1990s involved building only 19GW of new generation capacity!

Two options: change policy or hike prices
Our current renewable targets were drawn up with far too little thought or worse little understanding of the consequences for consumer bills. I believe at this point the Government has only two options, either change policy or convince the public that higher bills are worthwhile. Both require bold and radical action.

Which of course is possible - politicians can announce bold and radical policies – Ed Miliband announced a 20 month energy price freeze if Labour got into power at the next election. The problem with the policy is that it adds fuel to the fire rather than helping to solve the problem.  It has certainly helped ignite the debate about affordability and Mr Miliband personally gained a great deal of political capital but will it benefit consumers?

False hope
Sam Laidlaw, the CEO of Centrica, recently said that the price freeze creates false hope for consumers. We believe a price freeze would lead to higher prices in the long run for consumers for a number of reasons:

  • Global energy prices are not going to remain flat for 20 months simply because Mr Miliband wills it to be so, therefore energy companies will have to hedge forward power prices prior to the price freeze. If all the energy companies are trying to buy all their power needs in advance at the same time, for the same period, that will push up demand. Higher demand is likely to lead to higher power prices. 
  • Mr Miliband's comments mean it is less likely that energy companies will invest in new generation capacity in the UK. Given that 25% of the UK’s generation capacity is expected to shut in the next decade, new generation is needed and a slowdown in new build will lead to power shortages, which will likely lead to higher power prices.
  • Increased political risk increases the cost of capital, which means companies require a higher return on investment to offset higher risks. Which will likely lead to higher bills in the long term. 
  • Finally, if prices are frozen, what happens if global gas prices and therefore electricity generation prices fall during the freeze period - how is this passed onto consumers? 

If required, the energy companies will freeze prices for 20 months, but consumers should be under no illusion that this will mean lower bills beyond this.

On Monday, the coalition tried to draw a line under the affordability debate by announcing reductions to bills which will total £50 for the average dual fuel customer next year. This will be done by putting off some electricity distribution costs for one year, saving £5, moving the cost of the Warm Homes Discount scheme into general taxation, saving £12, and extending the deadline for energy efficiency measures to be installed by the energy companies, saving £35 on the average bill.

Little comfort for investors
The energy supply companies share prices have rallied marginally recently but that is little comfort for investors, who have seen the share prices of Centrica and SSE fall 15% and 16% respectively, since Ed Miliband first suggested a price freeze.

You therefore might be forgiven for being surprised that given this backdrop, the UK government announced changes to its Electricity Market Reform yesterday which focused entirely on support for new renewable generation. One of the biggest beneficiaries of these changes will be Drax, which has rallied strongly in the past 24 hours.

Ironically, it has historically been the UK’s largest carbon emitter, as it is the largest coal plant Europe. However, it is planning to convert half its plant to run on biomass rather than coal and is therefore eligible for government renewable support. Once all three units are converted, Drax will be one of the largest renewable generator in the UK. Drax, as purely an energy generator, is fortunate to have no residential energy customers, so currently sits on the right side of the energy debate.

Elaine Coverley
Head of Equity Research

Wednesday, 13 November 2013

Home Economics

Home economics - Inflation

If there are two pronounced trends in UK economic data at the moment they are rising house prices and falling inflation. Figures released yesterday by the Office for National Statistics show both: house prices rose by 3.8% in the year to September (HBOS estimate the rise at 6.9%) while consumer prices rose by just 2.2% over the last year - that’s much lower than the 2.5% expected. This is the slowest pace of price growth since 2009.  This sounds like good news and in many ways it is.  Today’s earnings figures, also from the ONS, show earnings growth of just 0.7% over the last year.  Prices have been growing faster than earnings for the past six years meaning the cost of living is going up in real terms. Lower inflation would lessen that real impoverishment that the average household is suffering although earnings growth needs to pick up for it to dissipate completely.

Inflation is an invisible factor that greatly influences the success or failure of a property purchase.  Whilst it is natural to think about a property in terms of what you can afford today, i.e. interest costs relative to disposable income, inflation will have a big impact in determining how indebted you feel over the course of the mortgage.

The average property in the UK costs approximately £170k according to figures from HBOS (up about £10k this year).  Back in the golden age of inflation, the 1970s, inflation ran at an average of 12.5% per year.  A loan of £170k in 1970 would have been worth just £50k by 1980 in real terms (after inflation adjustment) – inflation was the invisible friend helping you pay-off your mortgage. In the 1980s inflation averaged 7.5%, in the 1990s it was 3.5% and since 2000 about 2.5% (all using the retail price index to measure inflation).  A £170k debt discounted at the average rate of inflation over the last year would still be worth £130k.  Those about to buy a house will already resent the increases in house prices, but they should also spare a curse for low inflation.

Most economic forecasters are looking at better GDP figures and the booming housing market and are forecasting an increasing likelihood of an interest rate hike.  But with year-on-year earnings growth is still running at less than 1% surely that’s the last thing households need.  Bank of England figures show households overpaying on their mortgages faster as the economy recovers, despite historically low interest rates.  To my mind that suggests that the average household has a better understanding of economics than the average economist.

Guy Foster
Head of Portfolio Strategy

Wednesday, 6 November 2013

Correlation Street Repeats

It was exactly a year ago when we first highlighted our concerns that the ‘average’ IMA Target Absolute Return Fund was of little benefit to the ‘average’ equity biased portfolio in our Correlation Street blog. A year on and, as you will see from the below chart, nothing has changed*.
Source Brewin Dolphin

Given the persistent and high levels of correlation with the FTSE All-Share, it appears the typical ‘Target Absolute Return’ fund manager is merely assuming a modest amount of equity risk whilst leaving the vast majority of assets in cash. The net result for the client is simply a lower risk and lower return iteration of equity market performance. The sector, on average, therefore, is a poor diversifier of risk assets, and should be treated with trepidation in regard to the role in which it actually fulfils within portfolios. This is particularly the case given funds of this nature tend to levy a rather odious performance fee.

*For those less familiar with charting tools, please not the FTSE All-Share performance is plotted against the Left Hand Side axis, whilst the IMA sector is plotted against the Right Hand Side axis. This change in scale allows us to monitor the similarity in behaviour between two assets with a significantly different level of price volatility.

Ben Gutteridge
Head of Fund Research

Monday, 4 November 2013

Banks – What’s underlying the underlying?

Unpredictable, Unintelligible, Unsustainable, Incomprehensible: All words that could be used to describe some elements of the banking sector’s third quarter results.

There is no doubt that few could have predicted exactly what has happened in the third quarter with a weight of new information: ECB comments, Bank of England policies, Government disposals, Rights issues etc and the results certainly showed a considerable amount of variations. When banks release results, analysts have to consume a vast amount of information to try and comprehend the environment in which the company is operating. It is often the case that investors can be ‘pleased’ with the results despite losses, or relieved when figures seem to be worsening and this is due to analyst’s ‘cleaning’ the results to try and find what underlies the underlying results: is the core business making money? Rather than try and explain the benefits of these techniques, we believe it is as important to understand the factors which are impacting the results. Within the third quarter results, we would argue that there are six acronyms which impacted banks in different ways; namely:

  1. FICC (Fixed Income, Currencies and Commodities);
  2. FINMA (The Swiss Financial Market Supervisory Authority);
  3. PPI (Payment Protection Insurance);
  4. BRIC (Brazil, Russia, India and China);
  5. PRA (Prudential Regulatory Authority);
  6. FHFA (Federal Housing Finance Agency)

1. FICC stands for Fixed Income, Currencies and Commodities where banks provide a variety of trading, risk management, sales, structuring, financing, market analysis and strategy services across the globe. For big banks, FICC revenues are dominated by trading government and corporate bonds and the currencies of the world’s main economies. The third quarter results for all investment banks were dominated by the decline in trading income as revenues in their bread and butter business of bond and interest rate trading continued to decline after the prospect of a tapering of the Federal Reserve’s bond buying programme and low volatility hurt activity levels. Investment banks’ fixed income business traditionally accounts for more than half of their income but it has been under pressure this year as revenues fell and higher regulatory capital charges – as well as stricter trading rules – compressed margins.  Also, European banks were hit harder in the quarter as rates trading failed to repeat last year’s feverish levels spurred by Mario Draghi, the European Central Bank’s president, who said he would do “whatever it takes” to save the euro.

2. FINMA is the Swiss regulator and has certainly been active recently. It announced in the quarter that it, as well as the FCA in the UK and the US Department of Justice, was looking into possible manipulation of the $5.3 trillion daily global foreign exchange market. This was rumoured to be the case and both UBS and Deutsche Bank announced that they were co-operating with investigations. FINMA, however, surprised the market by ordering UBS to hold more capital for litigation risk. Management of UBS stated that this was a temporary 50% add-on to its risk related RWA in relation to ‘known or unknown litigation, compliance and other operation risk matters’. This is expected to result in additional operational risk-related RWA of approximately CHF 28bn on both a fully applied and phase-in basis which will reduce UBS’ fully applied Basel III Core Tier One ratio by 130 basis points. Management stated there is no transparency from FINMA as to how they came up with the new buffer need and there was no indication as to what items and business lines this refers to.

This was a concerning, if not unprecedented, move by the regulator and is another case of the regulator moving the capital goal posts. The news came as a surprise and UBS shares traded down 7%. It seems that as soon as investors start to think of increased dividend payments, the regulators will require more capital to be kept on the balance sheet. Don’t expect a quick return to dividend payments!

3. An increase in provisions for PPI hurt Lloyds share price on its results day despite it reporting ‘underlying’ earnings which were in line with expectations. The announcement that a further provision is being taken for PPI (£750m) which takes the total to near £8bn impacted net earnings figure. Management commented that ‘PPI complaint volumes have continued to decline, albeit at a slower than expected rate, while response rates to proactive mailing were higher than forecast’. This means that the capital position is not as a high as we were hoping or expecting. The Core Tier One ratio fell 10 basis points quarter-on-quarter to 9.5% due to PPI, pension volatility and share issuance. It is worth noting that if we include the disposals that were made post the quarter end, this figure is nearer 9.9%.

It appears that the scariest thing this Halloween may just be PPI which continues to haunt Lloyds and we were surprised by this further provision. What was bad news for Lloyds actually turned out to be good news for Barclays which announced no further PPI provisions; Barclays already provisioned £1.35bn in the second quarter. As at 30 September 2013, utilisation of the provisions for PPI redress resulted in a reduction in the provision by £387m to £1,263m, while utilisation of the provision for interest rate hedging products redress resulted in a decrease in the provision by £56m to £1,293m.

4. We all know about the growth potential of the BRIC economies but not all exposure is necessarily good exposure. Standard Chartered has had a tough year to date with the shares down nearly 4% compared to the FTSE 100 Bank index which is up over 10%. The third quarter results showed that trading was resilient, underpinned by continued strong client activity despite a volatile market environment. Management stated that the quarter started well but slowed as usual in August; yet the difficult market conditions that arose in August also had an impact in September. Management stated that the depreciation of a number of emerging market currencies, including the Indian Rupee and Indonesian Rupiah mean that, at current rates, there would be a full year impact of $200m on income and around $70m on profits. The impact of possible tapering of US bonds has caused much lower growth for many of Standard Chartered’s end markets and the volatility of currencies has impacted its performance. It may not be hugely exposed to Brazil and Russia but India and China are important factors in its growth trajectory. The results showed that Singapore and Korea are perhaps just as important.

5. The Prudential Regulatory Authority (PRA) has certainly made itself known since the split of the Financial Services Authority (FSA). Over the year it has taken steps to shore up the balance sheets of UK companies, specifically targeting a 3% leverage ratio. Barclays’ third quarter results were the first opportunity for analysts to assess the balance sheet post the rights issue and see what measures have been taken by management to deleverage. Overall the message was positive and should remove some investor concerns about reaching the targets that the PRA set it to achieve by June 2014. It does bring up a valid point though: what will be the next target and when is enough actually enough? The PRA wants to be leading the regulatory market and wants UK banks to be at the forefront of capital discipline.

6. It would have been hard for investors NOT to notice the size of the JP Morgan fine ($13bn) which was made during the quarter and although many of the calculations remain unknown, investors know the main damages concerned the Federal Housing Finance Agency (FHFA). These fines surround the misrepresentation the quality of the mortgages it sold to Fannie Mae and Freddie Mac, two government-backed mortgage companies. Bank of America said that it had nearly doubled the legal cost of the issue to nearer $5bn. Litigation is in the spotlight on the other side of the pond and we have no doubt that the focus will swiftly move East. At least nine banks are under investigation, including Royal Bank of Scotland. Below shows the potential litigation settlements for three UK listed banks based on our estimates; namely: Royal Bank of Scotland $2.82bn, Barclays $580m and HSBC $450m. Any potential fine is a large headwind at a time when management is trying to increase capital headroom and reduce volatility.

Ed Salvesen

Deputy Head of Equity Research

Tuesday, 15 October 2013

Passive Offensive

The 2013 Nobel Prize in economics has been awarded to Eugene Fama, Lars Peter Hansen and Robert Shiller, three economists with highly divergent views.   Most attention seems to be being heaped on Eugene Fama whose pivotal work on the efficient market hypothesis is often cited as sounding the death knell for active management and, for that matter, heralding a bold new world of indexing.

The efficient market hypothesis (EMH) is a rather dry concept which basically states that stock prices reflect all publicly available information on their respective companies instantly. By implication: seeking to outperform the market is a fool's errand.

There are a host of reasons why investors should tread warily down such a path. The first of which comes from the Nobel committee itself.  By awarding the prize to Fama they might appear to be acting as final arbiter in an ongoing debate over the EMH, but in truth they have actually ducked the issue, as the prize was also awarded to Robert Shiller, who has pointed out on countless occasions that the volatility of stock prices is so much greater than volatility of the dividends which they ought to reflect, that the EMH is implausible.

Professor Fama's colleague at Chicago Booth, and golf partner, Richard Thaler has become one of EMH's most ardent critics.  His provocatively titled paper, "can the market add and subtract" compares the prices of Palm and 3com during the tech bubble.

In that paper Professor Thaler recites the time when 3Com a computer networks and services company, sold 5% of its stake in Palm (an ill-fated provider of handheld computers). At the same time 3Com promised to spin off the remaining 95% later in the year with every share of 3Com yielding 1.5 shares of Palm. Immediately after the 5% stake was sold, 3Com shares traded at $80 while Palm shares traded at $95, despite maths telling investors that 3Com shares were definitely worth at least at least 1.5 times whatever Palm traded at.

Professor Fama, quips his friend, "is the only guy on earth who doesn't think there was a bubble in Nasdaq in 2000."

Of course the fact that markets are occasionally wrong, doesn't mean that they can be outperformed.  It is certainly true that most funds do underperform and mathematically half the funds invested actively against the market ought to underperform, adding in fees that ought to happen to more than half.  But it's far from impossible to uncover the gems that do beat the index.

Instead of discussing the process we follow to do just that it is more interesting to consider the record of the most famous active investor in the world.  Warren Buffett, in an event staged to celebrate the 50th anniversary of Graham & Dodd's seminal work on investing, Security Analysis, rebuts the EMH using his own record and that of other first generation and beyond alumni of the Ben Graham school of value investing to show that various forms of active management can yield excellent results based on just the simplest principle: seek to buy $1 of assets for 40 cents.

The essay Mr Buffet wrote to make this point (The Superinvestors of Graham & Doddsville) is as well-written as it is persuasive.

Guy Foster
Head of Portfolio Strategy