Charity investors warned about the dangers of the large debt overhang in the UK
February 2010
The state of the UK public finances means higher interest rates ahead at best, and at worst a nasty financing crisis, according to Guy Davies at Evercore Pan Asset.
The firm recommends starting 2010 with a balanced portfolio, with the exception that they are against any holdings in UK government bonds and prefer equities outside the UK. He explains:
‘The decade opened in the UK by a relatively fresh government promising us an end to “boom and bust”. We were told we would be run prudently, keeping a watch on the borrowing. The decade ended with the worst boom and bust cycle since the 1930s. It ended with bankers’ reputation in tatters, the UK government’s reputation for prudent finance and good management badly damaged, and the world community demanding more regulation after the worst regulatory failures of a lifetime. This is a difficult foundation on which to base the new decade. Charities have lived though difficult financial times, many calling on their reserves, while income has been scarce and in many cases cutting costs where they can. So as we start the new decade with fresh eyes and hopes for good things in the future, it is worth taking stock of our surroundings after the recent financial storm.
‘Notwithstanding the massive government stimuli and subsequent recovery in capital markets, the huge imbalances of the world economy which contributed to the crash have not gone away. In some cases they are becoming worse. The result of the debt overhang should be lower growth for the Western economies and therefore for the world as a whole. There may not be enough demand to sustain the highly aggressive export led growth models of China, Japan and Germany. If there is any squeeze on these exporting countries, brought on by weaker import demand elsewhere, China is likely to be the relative winner.
‘The large debt ridden positions built up by the main global banks, with all the attendant positions in derivatives, options and complex financial products, have also not gone away. There has been some reduction in risk, and large new sums of capital have been pumped in by governments and by the markets. There will be a long and slow workout, especially in the UK as the government is making heavy weather of tackling the big problems of RBS and Lloyds. There are hidden dangers lurking in some continental European banks, especially with their exposure to the distressed property sectors on both sides of the Atlantic, where there could be more grief despite the relative stabilisation of property market.
‘It is likely that we have seen the best of the asset price recovery, with the dramatic recovery in markets since March 2009, when there was a useful discount in prices. Pacific and Asian markets have performed better, reflecting the better long term growth prospects. Developed Western markets have moved on from trying to discount the much hyped Armageddon seen after the Lehman Brothers bankruptcy in October 2008.
‘As we look forward, we see two main themes that we believe will be important factors for charity investment. The first is the persistence of the trend to more and more success in the Pacific region, as manufacture, services and trade flow to and from Asia. This century will be dominated by the Pacific economies, just as surely as the 1900’s was centred on the Atlantic. The second will be the forced efforts of the developed economies to tackle the debt mountains built up in the good years, and added too during the recent financial crisis.
‘So faced with this somewhat gloomy picture, what are charity Trustees to do with their investment portfolios, in what many fund managers are predicting to be a difficult year for solid and safe returns. Entering 2010 by being fully invested, in a balanced portfolio of corporate bonds, growth market equities, property and commodities makes sense. Only hold back the cash you need for short term capital or income expenditure. The primary risk in the horizon is danger that world authorities cut back too quickly on the large amounts of liquidity they have created, and moving too rapidly to the higher interest rates that may be round the corner.
‘If the authorities are successful in 2010 they will end the quantitative easing, cautiously move to higher interest rates and allow growth to continue. The risks are on both sides of that careful balance. They could run the quantitative easing and low interest rates for too long, triggering another bout of inflation. Or they could strangle monetary growth too soon, and cause a further downwards movement in debt ridden economies. Either way, it is clear that the UK is at the risky end of the spectrum, with too much debt and too many difficulties. Therefore, it would be best for charity trustees to avoid the UK government bonds and equity markets, notwithstanding the likely need for income. The UK public finances are in a very poor state and the failure of the Pre-Budget report failed to spell out how the deficit will be tamed. This has started the legitimate market worries about how all the debt will be taken up once the Bank of England withdraws from the government bond market.’
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