5th May 2016
Rowan Dartington Signature’s managing director Guy Stephens says the main beneficiaries of the on-going downward pressure on interest rates have been other investment asset classes such as equities and property. But valuations look high.
The last week or so has seen a host of UK, US and European banks reporting their quarterly numbers. The reading has not been particularly pretty although this is no surprise with the turmoil seen in January and February. However not many people are shedding tears outside of the banks themselves but perhaps they should be, no matter how distasteful that may currently feel.
When banks are not making fat profits, capital is constrained, which means entrepreneurial endeavour is also constrained and that affects growth, today and in the future. Bankers are still viewed with disdain after the ‘Great Financial Crisis’ with much of the blame still parked at their door. If people are employed and financially motivated to make as much money as possible, by whatever means they can, then is it really entirely their fault when the regulatory rules are not robust enough to prevent them from being ‘creative’? We are all aware of the regulatory water that has flowed under the banking bridge since 2008, although earlier this year. There were serious questions as to whether there had been enough when Deutsche Bank was the subject of renewed fear over its viability.
The central bankers are continuing to implement policies to drive down interest rates in expectation that this will encourage borrowing, leading to investment and growth. In the acknowledgement that quantitative easing hasn’t been enough in Japan and Europe, we now have negative interest rates. The idea is that as this penalises banks for retaining capital, this will further encourage them to lend where previously they had not. It is probably true that banks have generally been inclined to hoard capital in an environment of continual fines for past misdemeanours but this would now appear to be subsiding now that there have been changes at the top of regulatory bodies, most notably in the UK.
However, it is questionable that there is actually sufficient demand from the economy rather than banks not being willing to lend. With GDP hovering around 2% in the UK with full employment, historically banks would have been in rude health. Instead, returns on equity are under pressure, costs are being cut and banking profitability is far from buoyant. It is therefore questionable whether the policy of negative rates will achieve anything other than provide a further headwind for affected banks who are already under margin pressure. Historically, banks employed traders to speculate with surplus balance sheet capital in order to make supernormal returns from the markets. Today, much of this proprietary desk activity has gone as it was the seed that grew into the self-destructive monster that was the ‘Great Financial Crisis’.
The main beneficiaries of the on-going downward pressure on interest rates have been other investment asset classes such as equities and property. These have attracted capital from institutions as they have sold their treasury holdings back to the central banks but have also been relatively attractive compared to fixed interest and cash which offer derisory returns.
At our asset allocation meeting last week, we remarked upon how expensive most asset classes look. Equities on an earnings basis, fixed interest on a yield basis and property less so but increasingly as demand rises. This is perhaps no surprise when so much money has been printed and pumped into the economy. However this hasn’t found its way into the economy but rather stayed in the financial system and not been put to productive use. The often quoted conundrum of poor UK productivity as the economy has recovered may perhaps be partly explained by this. The UK is principally a service economy rather than manufacturing and there is relatively limited demand for capital intensive investment. This led us to increase cash allocations across our investment profiles as we foresaw a period of weak US earnings and Brexit disruption to UK confidence and growth.
As far as the dreaded Brexit goes the bookies odds have moved more in favour of us remaining within the EU. This has been matched by a recent strengthening in sterling after support from Obama and a more general recognition that the US does not see this as a good idea and would weaken our special relationship. A ‘remain’ vote would probably be a positive for the markets as the status quo is preferable to uncharted territory. It is difficult for the ‘leave’ supporters to present what they would be able to negotiate ahead of the event and this will probably turn out to be their Achilles heel. Our largest trading partners (the EU and US) are both against it which does not augur well for easy negotiations post-Brexit.
At least last week saw the Federal Reserve remove its reference to ‘Global Concerns’ from the FOMC statement although most commentators now expect a rate rise in July rather than June in light of the soft Q1 US earnings season. The sooner US rates move further along their journey of interest rate normalisation, the sooner other countries may realise the fallacy of their continuation of QE and negative interest rate policy. This may then result in a healthy and robust banking system which is the lifeblood of a successful capitalist economic model.