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Investment Outlook

Apr-6-2017
By klein(WB)  | 0 comments

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Yesterdays winners eventually kill

By Noel O'Halloran, Chief Investment Officer  | 0 comments

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On a dramatic day for UK, European, and the global financial markets, Eoin Fahy, Chief  Economist, takes a look at the Brexit issue and in particular at five 'Myths’, that have arisen about what happens next.  

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The early weeks of 2016 were dominated by a very nervous and negative market environment, with headlines at the time being dominated by talk of the potential for global recession and persistent fears about deflation. The quarter ended on a much more confident note, with risk assets including equities rallying strongly and confidence restored in the global economic recovery and the health of the corporate sector. This ‘tug-of-war’ between for example; growth or recession, inflation or deflation, rate rises or rate cuts is something we as investors are now well accustomed to. As for outlook, we at KBI remain in the ‘glass half full’ camp as we have done since the global economic and market recovery commenced after the 2008 global crisis. Market volatility remains a constant feature as do the supportive actions of central banks, which once again came to the fore during the second half of the quarter. As such the first quarter of 2016 in many ways was a quarter of two halves, finishing on a more upbeat note. I continue to see equity market dips as a buying opportunity.

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Markets remain extremely nervous with headlines at present being dominated by talk of the potential for recession and persistent fears about deflation.

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Noel O’Halloran, CIO of KBI Global Investors got off to a flying start as an aeronautical engineer. The scientific approach this experience engendered has paid off in his current role.  By Mark Battersby

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Where to from here...can equity markets keep going? Despite the strong returns achieved last quarter, for euro investors in particular, I continue to take the ‘glass half full’ view and believe that equities can make further progress over the next 12 -18 months. It’s worth highlighting that in absolute valuation terms, equities are no longer cheap, as the MSCI World equity index is now on a P/E ratio (using 12 month trailing earnings) of 18 versus the 16.9 times historic average, and so equities are now above fair value relative to history. My core expectation from here is that further upward progress will be in line with earnings and dividend growth rather than by further P/E expansion. The slow-but-sure economic recovery we forecast will support this.

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During 2014 we recorded new highs for global equity indices as well as recording the sixth year in a row of positive returns from global equities. This was achieved despite many headline challenges be they geo-political or simply the ongoing challenges of the muddle through growth struggle for many of the world’s economies. From my general perspective, this constant ‘barrage of challenges’ to the recovery scenario was to be expected and has been a feature of the global equity recovery since March 2009. Global bond markets have also continued to hit new highs confounding all negative predictions (including yours truly) once again.

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There is more than a touch of “déjà vu” in the financial markets at the moment.  Yet again we are faced with speculation about a country (Greece) leaving the eurozone.  Once more we are looking ahead to what seems likely to be a year of very weak growth and inflation in the eurozone.  And of course we are again waiting to see what the ECB will do when it finally makes its mind up about how to react to these various issues.  In our view the markets are correct to be worried about these problems – they are very real – but it remains more likely than not that the outcome will also be the same as in previous years – a “muddle through” with no dramatic progress towards better growth and inflation, but no collapse of the eurozone, no country leaving it, and no severe recession either.

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 Since the current global bull market began during the first quarter of 2009 there has been a constant debate between bulls and bears about whether the markets are being driven by strengthening fundamentals or driven by free and abundant liquidity provided by central banks led by the US Federal Reserve. We have maintained a consistent view that the bull market has been driven by a combination of both liquidity and improving fundamentals. Markets themselves can be swayed by the additional ingredient of investor sentiment and as we know in relatively short time periods, investors can move from unbridled optimism to wholesale pessimism in a herd like manner. At present they appear to be veering towards the pessimistic side.

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In my beginning of the year piece, I expected 2014 to be another positive year for markets. As the first half draws to a close it has indeed turned out to be a positive period, with equities up 5.6%, bonds up 4.5% and commodities up 0.8% during Q2, which took the returns for the first half of the year to 6.9%, 10.5% and 7.8% for equities bonds and commodities respectively.[i] Many of the positive tailwinds that helped markets during 2013 prevailed in the first half of this year as well, with 2013 laggard assets such as Emerging Markets, commodities and Agribusiness related equities performing admirably.

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The results of the European Parliament elections have received a great deal of media – and financial market – attention.  Far-left and far-right political parties made strong gains in several countries, and those parties were in many cases in favour of their country withdrawing from the European Union and/or leaving the eurozone.  However, in other countries the results were very different, and we conclude that in reality little has changed and there is little chance of significant changes to key economic policies, or of “political gridlock” at European level.

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In the first quarter of 2014, investors were ‘hit’ by a barrage of macro challenges in the US, China and Eastern Europe, and investors also fretted about whether Japan and Europe were gaining the upper hand in the battle against deflationary challenges. In the US, very severe winter weather was the presumed cause of a significant decline in economic activity.  In China, the economy slowed sharply- leading to expectations of a government stimulus package – and to cap it all the crisis in Ukraine raised geopolitical tensions across Eastern Europe and beyond.

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Donore Harriers athlete John Travers has won the 2014 St. Patrick’s 5K Festival Road Race, which took place in Dublin on Sunday 16th March. He completed the course in a time of 00:14:07.

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Having remained optimistic throughout 2013, I believe that 2014 will continue where 2013 left off and at this point am not advocating any changes to the “positive positioning” we have in place for discretionary client portfolios. I expect 2014 to be another positive year for global equities with bond markets once again struggling. Equity valuations are no longer cheap but equally they are very far indeed from what would be considered ‘bubble-like’.

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As Ireland exits its three year troika bailout period, it is a good time to ‘take stock’ of the deficit and debt situation for the country. How big is our debt relative to history and to other countries? How much work needs to be done to get the budget to balance again? Do recent good economic data (rising employment, falling unemployment, etc) make a big difference to our fiscal situation?

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Noel O'Halloran, CIO, spoke at the CEF Conference in New York on 6th November on the topic of the Irish economy. The presentation is called 'Celtic Comeback Continued'.  Click here to view the webcast and here to view a PDF of the presentation.

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Budget 2014 was the first budget to deliver less, in austerity measures, than the amount agreed with the troika.  Indeed, it is a mark of how the balance of power has changed between Ireland and the troika that the government could reduce the size of the austerity package by €600m, and in reality there was very little that the troika could do about it. On the whole, this decision can be justified, but it's a close call as there was also a good case to be made to make quicker progress towards debt reduction.  After all, Ireland will still borrow close to €10bn this year, adding to an already-high stock of national debt.  The key issue now is whether Budget 2014 is the first step towards walking away from a sensible fiscal policy designed to get our debt under control, or simply a pragmatic recognition that the austerity package this year need not be as large as previously thought.  The jury is out!

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See below for a list of the principal measures in the Budget, or click here for a commentary on the overall Budget.Overall Budgetary Position: The main domestic measure of the budget deficit, the Exchequer Borrowing Requirement, will be 4.8% of GDP in 2014, down from an estimated 7.3% this year.

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Optimism maintained

By Noel O'Halloran (CIO)  | 0 comments
I remain upbeat on the outlook for global equity markets and at this point am not proposing any material changes to the ”positive” positioning in place for discretionary client portfolios.  The fourth quarter of the calendar year has historically been the strongest quarter for equity market returns.  Since the lows of 2009, much of the strong performance of global equities is due to valuation expansion driven by the extraordinary efforts of global central banks to restore growth, rather than any strong underlying dynamic from economic or profits growth.  In contrast, the next period of returns will be increasingly dependent on evidence that economic growth is accelerating and translating into continued profits and dividend growth.  In 2014 as central banks slowly retrench (led by the Fed) further equity gains will require fundamental evidence of growth rather than central-bank-inspired hope!

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Cautious welcome for Fed surprise Last night’s announcement from the Fed that it would not change the pace of “money creation” was a complete surprise.  While good for markets, certainly in the short-term at least, we caution against excessive optimism until the reasons behind the decision are fully clear, not least because markets like certainty – something that is clearly now absent in relation to future US monetary policy.

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Institutions ranging from universities to public pension funds are under increasing pressure to consider divestment from fossil fuel companies whose activities are leading contributors to climate change. While much of the attention has been focused on whether or not to divest, the discussion is evolving to include ways to manage a multifaceted investment challenge. The traditional belief of many investors has been that fossil fuel stocks are essential to generating portfolio returns. However, it is our contention that the sources of return that fossil fuel stocks have been relied upon to deliver can be replaced by investment in other vital resource solution providers, and when adequate consideration is given to the significant risk from carbon exposure that fossil fuel stocks pose, investment solutions can be created that are in the best interest of both institutions and our global society.

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Upbeat outlook maintained

By Noel O'Halloran (CIO)  | 0 comments
Upbeat outlook maintained Despite the recent volatility of markets, I remain confident on the outlook for equity markets from here.  Unless there is a significant policy mistake by a major government or central bank (which is unlikely), the macro environment will remain positive while valuations are also attractive.  We are not making significant changes to our positioning or forecasts.

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The first quarter of the year turned out to be very strong for equity markets in particular. The strong returns were driven by a combination of a better macro outlook for 2013 and investors’ increased appetite for risk assets.

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It has been a fairly bizarre 24 hours in Ireland, starting with leaks of an IBRC liquidation, then an all-night legislative sitting to pass emergency legislation, and ultimately ending with the ECB “unanimously taking note” of what seems to be a fairly credible and helpful deal on the promissory notes (details of the deal are below).  As the dust settles, Ireland is left with a significantly reduced cash outflow over the next ten years, and a reduced national debt in current value terms. So we can chalk it up as a win for Ireland, notwithstanding the odd circumstances.  Unambiguously Ireland is in a healthier position than it was before this deal. 

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KBI Global Investors (KBIGI) today announced a strategic alliance for the US market with Virtus Investment Partners, which operates a US-based multi-manager asset management business.   Sean Hawkshaw, KBI CEO, commented that Virtus has a proven track record in retail distribution, while the benefit to Virtus is that it gains access to KBI's institutional-quality investment processes specialising in income-oriented equities and resource strategies.  

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2013 Outlook: More of the same

By Noel O'Halloran, Chief Investment Officer  | 0 comments
2012 was a very good year for asset returns with the MSCI World equity index rising by 14.7% in euro terms (16.4% in local currency), and the over 5-year eurozone bond index returning 15.4%. I had expected a positive year for returns but the eventual outcome was even more positive than I expected at the beginning of the year. As I look back on the year, the world did not end, many potential bullets and landmines were avoided, and unusually both risk assets (equities) and defensive assets (sovereign bonds) returned strong double digit returns. We avoided a euro meltdown or Chinese hard landing and a resolution, of sorts, was found for the US fiscal cliff issue. From my perspective the central bankers in whom we placed much faith in our views and decision making over the last 18 months “delivered” and Draghi at the ECB well deserved his award as “Financial Times Person of the Year”.

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Today’s Budget was very much as expected, both in its overall shape and as regards the detailed changes in it.  The modest stimulative measures aimed at the SME sector are helpful, but are very unlikely to have an immediate measurable impact on the economy, though they were probably a political necessity to show that the government is “doing something” to deliver economic growth.  The budget deficit will still be 7.5% of GDP next year, or €15.4bn, so more austerity is a certainty for at least the next two budgets, but the good news – such as it is - is that Ireland is perhaps 85% of the way through the austerity programme, if economic growth holds up as expected.   Very often, the main focus on Budget commentaries and media coverage is on a small but highly controversial measure.  This year, it seems probable that the new property tax will hog many of the headlines, but this new tax will raise far less than 1% of total tax revenue next year, and makes up less than 10% of the total austerity measures in this Budget.   So while the introduction of a property tax is noteworthy, it is also important to focus on broader and more relevant budgetary issues. Tax Rates Unchanged On broader issues, the government kept its commitment to avoid raising income tax rates, despite some suggestions that the Labour Party was pushing for a steep 3% increase in the Universal Social Charge rate for higher earners.  Marginal tax rates are important: too high a rate will discourage entrepreneurship in an economy and thus stifle economic growth, so the abandonment of this plan is to be welcomed.  Other measures such as pension tax relief restrictions will hit higher earners, of course, and all earners will be hit by the abolition of the weekly PRSI allowance, but these measures are a better way to raise revenue than an outright increase in the marginal rate of tax. 

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See below for a list of the principal measures in the Budget, or click here for a commentary on the overall Budget.Overall Budgetary Position:The main domestic measure of the budget deficit, the Exchequer Borrowing Requirement, will be €15.4bn in 2013, down from an estimated €16bn this year.  This still represents a frighteningly large 36% of all government revenues.  If no austerity measures were introduced in the Budget, the deficit would have risen to €17.8bn next year.As a percentage of GDP, the deficit (using the EU measure) will be 7.5%, down from an estimated 8.2% this year.  Without the measures in this budget, the deficit would have risen to 8.9% next year.Total revenue will rise by 3.6% to €42.3bnTotal spending will rise by1.8% to €57.7bn, of which €49.9bn will be for day-to-day spending and €8.1bn will be for capital spending.Taxation:The weekly PRSI allowance has been abolished.  Until now the first €107 of income was exempt from PRSI.  This measure will cost each earner about €250 per year.Tax relief on pensions is being restricted.  From January 1st 2014, tax relief will only be available for pensions funds which "deliver income of up to €60,000 per annum".  Consultations will be held to work out the details of this new restriction. Tax relief will continue at the marginal rate, subject to the €60,000 restriction.  The pension levy is to be scrapped after 2014, as previously promised. Redundancy payments and ex-gratia pension lump sums will no longer be eligible for "top slicing relief" if they are exceed €200,000.For the first time, withdrawals from pension scheme AVCs will be allowed before retirement, although they will be taxed at the marginal rate of tax.  The max withdrawal will be 30% of the fund.  It will be allowed for three years only.Excise duty on cigarettes has been raised by ten cents.  Excise duty on beer has been raised by ten cents per pint, on whiskey by ten cents per measure, and on wine has been raised by one euro per bottle, from today.Excise duty on petrol and diesel will remain unchanged, and a rebate scheme has been introduced for diesel duty paid by hauliers.A number of minor measures have been announced to aid the SME sector, including a higher R&D tax credit, a higher cash receipts basis threshold for VAT, extra funds from the National Pension Reserve Fund for the sector, and other miscellaneous measures. Real Estate Investment Trusts (REITs) will be allowed under new legislation, which is expected to make Irish commercial property more attractive to overseas investors.As expected, a new Local Property Tax will be brought in from July 1st, at a rate of 0.18% of the value of the property up to €1m, and 0.25% above that level.  To help taxpayers, the Revenue Commissions will provide "valuation guidance" to which owners can refer.  The initial valuation will remain unchanged until 2016.  There will be a "banding" system, with €50,000 increments, and the tax payable will be set at the mid point of that band.  Local authorities can raise or lower the tax by up to 15% from the centrally-set government rate, but only from 2015 onwards.  The Household Charge will be scrapped.

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As of November 1st 2012 dealing on all sub-funds in the KBI Global Investors Institutional Fund PLC and the KBI Global Investors Investment Fund has returned to normal.

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  It would be going much too far to say that the last few days were “the week that saved the euro”, but real and substantial progress has been made, and the eurozone is in a far stronger position today than it was a year ago. We believe that the risk of a major crisis in the months ahead has fallen substantially and a “muddle through” scenario is now far more likely.

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With the widespread drought continuing across the United States, water is very much in the news.  Which, in a way, is good.  We generally take access to clean water for granted.  Delivered from far away reservoirs or underground aquifers, it is essentially out of sight and out of mind until the tap turns on. But nothing sharpens our focus on what matters more than tragedy.  Drought is a tragedy, and water is, and should be, a priority.  Please click through to the blog entry to read more about this topic.

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Our Chief Economist, Eoin Fahy, was interviewed on RTE TV's "Primetime" current affairs programme on August 2nd, to discuss the ECB's announcements that day.  Click here to see the programme.

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Second half: more of the same?

By Noel O'Halloran, CIO  | 0 comments
As we enter a new quarter, I want to share with readers my expectations for the next few quarters, and in particular my expectations for developments in the eurozone fiscal crisis. In short, I believe that the euro will survive, and that although we are living through a period of historical change in the eurozone, a large “risk premium” is priced into markets already, and as markets begin to price in 2013 earnings, a more positive tone will emerge.

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The deal agreed at last night's EU summit contains a number of references to "could", "consider", "possibility", "should", "examine", and "urge". In other words, it is far from a done deal. But it would be wrong to be too dismissive of the deal - it represents a substantial change in Germany's attitude to this crisis, under extreme pressure, and has the first explicit commitment to look favourably at Ireland's "bank debt" issue. It's too early to conclude that this is a turning point in the crisis - but certainly too early to conclude that it is not!

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World Finance magazine has published a profile of KBI Global Investors.  Dublin-based dividend expertise KBI Global Investors is taking an innovative approach to dividends and doing its bit to help the environment at the same time.........

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Election Weekend

By Eoin Fahy  | 0 comments
Elections were held in Greece and France at the weekend, and in our judgement, the results of  the Greek elections in particular have adverse consequences, in the medium term, for the stability of the eurozone.  The damage, however, was by no means unexpected and the threat is not immediate.

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Bonds - The Next Bubble?

By Noel O'Halloran  | 0 comments
Many investors believe, or are being told, that they can “de-risk” their investments by shifting assets out of equities and into core European government bonds. However, it is my view that government bonds will in fact be the weakest asset class over the next decade so there is a real danger that investors are switching into an asset which is seriously overvalued. Government bonds, even German government bonds, are NOT risk free! Bonds have, it is true, outperformed equities over the last decade. But such outperformance is extremely rare. A decade ago, the strong performance of equity markets over the previous decade gave strong but mistaken comfort to those holding high levels of equities. There is a real risk today that the same mistake could happen again, this time as investors move heavily into very low yielding government bonds (German government bonds yield only about 2%).

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Against most expectations, the Government has announced this afternoon that a referendum will be held on the "fiscal compact" deal. At a time when many things seemed to be going well for Ireland, this throws the cat among the pigeons and raises serious risks about Ireland's ability to continue to receive bailout funds after next year. This uncertainty is likely to continue at least for a couple of months, and there is of course absolutely no guarantee that the electorate will vote Yes.

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Last week the Central Bank published statistics that showed that about 12% of mortgages are  in arrears, which is obviously a very high proportion and a source of great concern.  But even that very high level of arrears is still well below the "stress test" assumptions used last March to determine how much capital the 'covered' banks need.  The hard-pressed Irish taxpayer still seems unlikely to need to plough even more money into the banks.

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A Year of Two Halves

By Noel O'Halloran  | 0 comments
Asset returns in 2012 will be positive but most likely modest. The first half of the year will remain tricky and will be similar to H2 2011, as equity markets are set to remain range bound and volatile. The two major debates surrounding the state of the global economy and the fate of the eurozone will continue to dominate. For the second half of the year, there are reasons for optimism and I expect a more positive environment.

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The principal measures in Budget 2012 are listed below (see separate note and blog entry for a Budget Commentary).

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The Irish government no longer has control over the “big” budgetary numbers, as the troika essentially dictate the overall shape of the budget.  The government’s remaining decision powers relate only to whether to go further than the minimum troika-agreed cuts, and exactly how to implement them.  The fact that the austerity measures were at the lowest end of what was required is disappointing, but perhaps understandable.  And on a positive note, the details of the austerity measures were reasonably well-judged, with a focus on spending cuts and increases in spending (not income) taxes. 

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Six central banks, including the European Central Bank and the US Fed, announced this afternoon that they are taking coordinated action to ease strains in financial markets and to help economic activity. A seventh, China's, announced at much the same time that it was easing monetary policy in a different way.  However, the 'coordinated action' is far from dramatic and certainly doesn't come close to being the radical step that so clearly is required to deal with the eurozone fiscal crisis.

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ECB Acts

By Eoin Fahy  | 0 comments
The European Central Bank has just announced that it is to cut its key interest rate by one quarter of one percent, taking the rate to 1.25%, and left the door open to future cuts in the months ahead.  This was an unexpected decision, at least with regard to its timing, and will provide some modest help to the eurozone economy.  However the crisis has reached such proportions that a mere 0.25% cut in interest rates certainly does not represent a dramatic step.  Greece remains the centre of attention.

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So in the middle of the night European leaders concluded yet another crisis meeting. Whilst a major step in the right direction the deal is far from the “Grand Plan” promised many weeks ago. The initial knee jerk equity market reaction this morning is positive, but probably as much because the agreement is better than the markets feared as anything else. A sustained rally in European equity markets on the back of this announcement seems unlikely. However, the agreement itself is meaningful and the measures it proposes and the message it sends should be sufficient to underpin the markets and prevent the downward spiral many commentators feared over recent weeks.

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Threat or Opportunity?

By Noel O'Halloran  | 0 comments
I last gave an update on our investment views in mid August following the downgrading of the US sovereign credit rating by S&P.  Market sentiment was then negative and concerned about a relapse into a double dip recession in the US economy. At that same time the ECB announced a bond buying programme targeting Spanish and Italian bonds in particular. Since then the markets very quickly moved on from the US debt downgrade and focused initially on US economic data and then the political future for the Euro zone.  Over the quarter as a whole, the world equity index fell by 9.8% in euro terms, or 16.5% in US Dollars, while European government bond prices rose.  Clearly it was a very poor quarter for equity investors, and we need to decide whether this weakness represents a warning of further weakness to come, or creates an opportunity for investors to buy cheaper assets.

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Allez Les Bleus!

By Eoin Fahy  | 0 comments
Despite rumours to the contrary, it's extremely unlikely that France is about to lose its AAA credit rating.  While the US did lose its AAA rating last week, its finances are considerably poorer, as I outline in brief below.

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Market View: 10th August 2011

By Noel O'Halloran  | 0 comments
The global equity markets bottomed in March 2009 and performed strongly from then up to Q2 of this year.  Up to recent weeks equity markets traded sideways in a volatile 5% or so trading range. Most recently the markets have caught fright and have fallen sharply, breaching the lower end of the established trading range, and are now typically 15% below the Q2 highs.

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The Italian Job

By Eoin Fahy  | 0 comments
Yet again the main focus of the financial markets over the last week has been on the eurozone sovereign debt crisis, with attention this time turning to the sudden sell-off of Italian bonds and the truly frightening possibility emerging that Italy might not be able to borrow on the financial markets.  European authorities find themselves - again - faced with the need to take radical and effective action to reduce financial markets worries. Fast!

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The second quarter just ended was a bumpy quarter which saw world equity markets fall by 1.5% in euro terms, while government bond markets made modest positive returns (1.6% as measured by the ML benchmark 5 year+ index).

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Two of the three main credit ratings agencies have updated their views of Ireland, and they have differed strongly in their outlook.  Moodys have downgraded Ireland by two notches, while Fitch has reaffirmed its (higher) rating and removed its warning of a possible downgrade.  The market impact has been limited.

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Q2 Outlook

By Noel O'Halloran  | 0 comments
The first quarter of 2011 saw world equity markets rise in local currency terms (the MSCI World Equity Index rose by 3.7%), although the strength of the euro against many currencies eroded those gains when translated into euros.

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Q&A on Stress Tests

By Eoin Fahy  | 0 comments
Yesterday’s blog entry (click here to read) contained a quick summary of the stress test results, and some initial reactions. Today, as the dust settles, I set out my more detailed views, in question and answer format.   Q: Are the economic assumptions behind stress tests severe enough? A: The tests assume a very very poor outcome for the economy and – even more so – for house prices.   House prices are assumed to fall 16% this year, then another 19% next year. In contrast, a Reuters survey of economists showed that the consensus expectation is for a fall of 5% this year, and increases of 2% and 4% in 2012 and 2013. So the stress tests assume that house prices fall by 35% from here, while the consensus is for house prices to be broadly flat. The tests also assume a 20% fall in commercial property prices, and a significant further decline in GDP.   While nobody can ever say with 100% confidence that this outcome is the worst conceivable outcome, it is certainly a very negative outlook indeed. I can think of no justification for the tests to have been any tougher than they were.   Q: Are the loan loss estimates realistic? A: For this exercise, the losses were calculated not by the banks, but by an external consultancy house who looked at the loan books of the Irish banks in great detail. They used comparisons from the UK and the US, not Ireland, to work out how bad the loan losses could be. This is very important because history tells us that loan losses (and repossessions etc) have been far lower here than in other countries, presumably because Irish people are much more attached to their house and their land than other cultures.  Also Irish banks tend to be much slower than in other countries to foreclose on homeowners who get into difficulty. But these factors are explicitly NOT taken into account in the stress tests.   Turning to the actual numbers, the forecast for loan losses on mortgages over the lifetime of the loans is put at 12%. In other words, for every €100,000 of mortgages outstanding, the expected loss on that mortgage is expected to be €12,000. In contrast, the banks themselves say that - even using the same assumptions for growth etc - they think the total loss would be only 4.5%. For loans to large businesses, the lifetime loan losses are forecast to be 5.8%, in the stress test scenario, while for small businesses the forecast write off is a very large 19%. Loans to consumers (ex mortgages) are expected to see write-offs of  27%.   In total, for all loans, the external consultants forecast losses of 14.6% over the lifetime of the loans, while the banks’ own forecasts were far smaller, at 8%.   Over the next three years alone (the period of the stress tests), the expected losses of the four banks would be 10.1%, or €28bn.   As with the economic forecasts, it is impossible to say with 100% confidence that the eventual outcome could not possibly be any worse than that. But certainly these are very, very, pessimistic assumptions, and in the absence of a further very large and dramatic downturn in the economy in the next year or so, it’s hard to see how the eventual outcome could in the end be worse than these forecasts.   Q: Is this the last time the banks will need more capital? A: Again, nobody can be 100% sure of this. But as I have said above, both the economic assumptions and the expected loan loss assumptions are very pessimistic indeed, and the tests were carried out by consultants completely independent of the banks (unlike previous times). So on the whole I genuinely do not see further capital being required for these banks (though Anglo is another matter, see below), but it would be a very foolish person who would completely rule it out!   Q: What is the cost to the taxpayer of the €24bn being put into the banks? A: Of the €24bn, about €8bn is estimated to be in the form of new borrowing. Some of the remainder will come from the National Pension Reserve Fund, and some from further write-offs of bank subordinated bonds. The cost to the taxpayer, per year, of the additional €8bn that will be borrowed from the EU/IMF, will be about half a billion euros per year. There is also a further ‘notional’ or opportunity cost, in the sense that the money being taken from the pension fund would presumably have made a return, that will now not be made.   Q: Does the EU/IMF deal have to be renegotiated, as the banks now need all this extra capital? A: No. The deal always had a provision for a definite €10bn to be given to the banks in extra capital, and a possible further amount of up to €25bn, giving a total of €35bn. The tests yesterday concluded that the amount required was €24bn. This was some €11bn less than the maximum envisaged under the EU/IMF deal, so the deal has not been breached.   Q: Is it disappointing that the ECB has not provided (as rumoured) a medium-term financing arrangement for the Irish banks? A: Yes. Essentially the Irish banks have what might be described as an “emergency overdraft” from the ECB. It was strongly rumoured this week that this overdraft was, in effect, to be converted to a long-term loan, but this has not happened. While the ECB announced last night that it is easing the rules for Irish banks wanting to access that overdraft facility, that is definitely not as reassuring as if the ECB had announced a full conversion to a proper medium term loan. The ECB is of course expected to continue funding the Irish banks, but “expected to” is not as good, obviously, as “legally committed to”. This was a genuinely disappointing aspect of yesterday’s announcements.   Q: Why are unguaranteed senior bank bondholders escaping without any losses? A: In short, because the ECB is afraid that if Ireland sets a precedent of not paying back bank bondholders, other banks across Europe might do the same, and then the whole European banking sector (which holds large amounts of those bonds) could be in serious trouble.   Frankly, this is daft. The same people in Germany and the ECB in particular who on the one hand are insisting that in future any bailouts for countries that get into difficulty must be accompanied by write-offs for sovereign bond holders, are at the same time insisting that lenders to banks today which are already insolvent, or close to it, must be paid back in full. But daft or not, the Irish authorities just don’t seem to be able to overcome the ECB’s (absurd) opposition, so the question of unguaranteed senior bank bondholders taking some pain seems to be completely off the table. It makes no sense, but we are stuck with it.   Q: Why are Anglo and Irish Nationwide not included? A: The answer given by the authorities is that “Anglo and INBS were not included in the stress testing exercise…as the institutions were in the process of implementing the restructuring plan” [the plan submitted to the EU for approval in Jan 2011].   They also stated that once the two banks are merged, they will have a core tier one ratio of 12.5%, which is high. Interestingly, the central bank applied the results of the stress tests for the other banks, to the Anglo loans, and concluded that the most recent capital assessment for Anglo already had more pessimistic outcomes built in than the results of the stress tests.   While not formally stated, it may well be the case that given that these banks will not be making any new loans, they do not need as much capital as the banks that are still alive and lending to customers.   Q: Why was AIB picked to merge with EBS, instead of Bank of Ireland, given that Bank of Ireland is stronger? A: I don’t believe that the authorities have formally answered this question, but presumably it is because the state controls almost all of AIB, but less than half of Bank of Ireland, and so it is significantly easier to implement a merger with AIB (which the state already owns and controls).   Q: Where do we go from here? A: The stress tests obviously deal with the banking sector and the capital required for that.

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Ireland downgraded

By Eoin Fahy  | 0 comments
Credit ratings agency S&P has just downgraded Ireland by one notch, to BBB+, and (very importantly) changed the outlook to ‘stable’ from ‘negative’.  All three agencies now rate Ireland at BBB+ or equivalent, that is three notches above non-investment grade.   The downgrade was expected, but many people expected the downgrade to be of more than just one notch, and the change to a 'stable' outlook was also a surprise, in my view.   The downgrade was because of the new European arrangements agreed last week, whereby sovereign debt restructuring/default is a possible precondition to getting a bailout from Europe, post 2013.   The commentary was actually quite positive about the stress tests, describing them as “robust”, and said that the cost of the recapitalisation of the banks is within the range of S&P’s expectations.   It also said that the sharp contraction in the economy has reached an end, and that the economy is now set to gradually recover.   If a downgrade can ever be seen as 'good' news, this one probably is, due to the positive remarks about the stress tests and the economy, as well as the change to a stable outlook,     The bond market reaction has been muted but positive.  Irish bonds opened stronger this morning after the stress test results were announced yesterday after the close of business, and have held those gains in the wake of the downgrade from S&P.

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Overall Comment: The total amount needed in extra capital for the banks (€24bn) is very much in line with expectations.  But the surprises are that there is no annoucement re an ECB medium-term liquidity provision (i.e. no conversion of emergency lending into longer-term funding) and there does not appear to be any suggestion that senior bank bondholders will be “burned”.  These are both things that the government and Irish authorities badly wanted, so it appears that they have either lost the debate with the ECB, or that the issues are still being debated at EU level.   Stress Test Assumptions: Banks must have a 6% core tier 1 capital ratio in the stressed scenario (this compares with 4% in the last stress tests).  Repossessions and losses on mortgages are assumed to be as bad as in the US (in practice the authorities do not think that losses will be anywhere near as bad as that).  Results: Total capital required: €23.6bn. Of the total, €18.3bn is the amount required under the stress test per se, but the regulator has added another €5.3bn as a capital buffer to take account of further losses after three years (the stress tests cover only the next three years). The €23.6bn figure is before any asset sales by the banks and before any write-offs of subordinated bank bonds, so the actual costs to the taxpayer will be lower.  Losses are assumed to be 6.7% of mortgages, 4.9% of corporate loans, 12.3% of small business loans, 22% of property loans, and 21% of consumer loans.

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A reduction of 1% in the interest rate paid by Ireland on the EU rescue package would reduce the country’s annual deficit by less than 3% of the total, yet it has become a near obsession in our political system. It’s time to focus on the other 97% of the deficit, and the banking system mess, and to stop obsessing about a relatively trivial issue which is important only in political circles.   The maths relating to an interest rate cut are not remotely complicated: there are no complex assumptions or workings involved. We are due to borrow €45bn from EU countries over the three year period of the rescue package. So a 1% cut in the interest rate would save €450m per year.    Now €450m is a substantial amount of money, and if we can get it, great! But to listen to much of the debate in Ireland, and particularly the political debate, one would think that if only we could get a cut in the interest rate, we would be well on the way to getting our public finances under control, and would be in a much stronger position to deal with the problems in the banks.   Frankly, that is utter nonsense.   Let’s put that €450m in perspective: The budget deficit this year – the gap between spending and revenue – is expected to be about €18bn. So the €450m potential saving would equal 2.5% of the deficit. This year’s budget contained €6bn of austerity measures for 2011 alone, in tax increases and spending cuts. €450m is about 7.5% of that amount. The four year National Recovery Plan builds in total budgetary cuts or tax increases of €16bn. That's 36 times the size of the €450m interest rate saving! Total tax revenue this year will be around €32bn, so the €450m saving would be about 1.5% of that amount. The Irish banks have emergency, short-term lending from the European Central Bank and the Central Bank of Ireland of around €150bn. While one is a stock and one is a flow, so the comparison isn’t entirely valid, it’s worth noting that the €450m is just 0.3% of that amount. It's plain to see that the €450m interest saving is not much more than a rounding error in Ireland’s fiscal accounts. The upcoming banking stress tests, and the severe cuts still to come in the next few budgets, are vastly more important to Ireland than this side-show.    Will the new government continue with the planned austerity measures? Will the banking stress tests mean that all of the €35bn set aside for bank capital will be used up? What will happen to the €150bn in “emergency” lending to the Irish banks, can it ever be repaid? Will Irish banks be allowed to default on some or all of their bonds?   These are the real issues facing Ireland over the next few weeks and months.

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Japan Disaster

By Eoin Fahy  | 0 comments
The appalling tragedy and ongoing crisis in Japan have shocked everybody, and we would like to join with so many others around the world in offering our sympathies to all those affected.  In the comments below, we give our initial thoughts on the impact of the tragedy on the financial markets, while of course recognising that such issues are trivial in the context of the huge loss of life.  In short, this crisis does not (significantly) change our global macro outlook, but the risks around that outlook have clearly increased.   Market reaction: unsurprisingly, Japan most affected. Japanese equities have obviously taken the brunt, and since the day before the earthquake are down around 18% in local currency terms.  Equities in the rest of the region are down much less, about 2%, while European equities are down around 6%, and the US market is down about 2%.   Currencies have not moved very significantly.  The Japanese Yen has strengthened about 2% against the Dollar (partly as markets expected large insurance claims to be paid to Japanese residents from overseas insurance companies, and that Japanese companies would repatriate overseas money to help deal with local problems).  The euro’s exchange rate against the Dollar has been fairly stable as well, rising by less than a percentage point.   Commodity prices have been mixed.  The oil price has fallen around 4%, and agricultural commodities are down around 3%, but gold and silver are broadly unchanged, as are industrial metals.  Natural gas has strengthened somewhat.    Bond markets have varied.  In Japan, bond yields have fallen by about 0.1%, while they are roughly unchanged in Europe and the US.   Surprising impact on Japanese economic growth Turning now to the impact on the Japanese economy, it is obviously far too early for anybody to have an accurate estimate of the direct cost of the damage done by the earthquake and tsunami.  But the strange thing is that GDP is not directly impacted by the physical damage done in a natural disaster.  GDP is a measure of the production of goods and services in an economy, not the stock of infrastructure, so the immediate impact on GDP will be limited to the extent of the lost production in the aftermath of the disaster.  That impact can’t be properly quantified, but we do know that the affected region produces about 2% of Japanese GDP, so in that sense the impact is quite small.  But of course outside the directly affected region there will be many businesses that have reduced production, either due to the inability of workers to reach their workplace (roads and public transport are still disrupted), or because of the unavailability of essential components which are, or were, produced in the affected areas.   Once normal production resumes in the rest of Japan, as it surely will quite quickly assuming the nuclear situation does not drastically worsen, then in fact the impact on Japanese GDP could be positive.  This is because GDP, as mentioned above, does not take account of the damage to infrastructure, but does include all the reconstruction activity, and clearly there will have to be a great deal of reconstruction due to the enormous devastation.   However, it would be wrong to focus only on Japan.  Japan is one of the world’s largest exporters and importers, so the crisis there does have a knock-on impact on other countries.  On the whole, though, such impacts are likely to be quite short-lived, I believe.  Certainly many companies will have difficulties in sourcing products that they used to buy from Japanese companies in the affected areas, but with some exceptions it seems reasonable to think that there are very few products or components which are ONLY produced in that particular part of Japan, and which can’t be found elsewhere.  Of course, prices of some products will rise, as is always the case when supply is restricted, and this may affect the profit margins of some companies.  But again, the affected area of Japan is only 2% of the Japanese economy, so apart from some very short-term disruption due to closed ports etc, it seems reasonable to think that in the medium term the impact on global growth and global inflation will be fairly minimal.   Large risks remain There remain very substantial risks, particularly from the nuclear power station situation.  The news here changes rapidly, but as of the time of writing it seems that the situation is more akin to the Three Mile Island disaster in the US in the 1970s than to the Chernobyl situation in the 1980s.  In other words, it does not seem likely that a huge portion of Japan will be "poisoned" and closed off to human occupation for many years.  However, if the situation worsens drastically, to become more like Chernobyl, the economic impact would of course be far larger.   Other risks include the very poor fiscal sitation in Japan.  The national debt in Japan is even larger (relative to the size of its economy) than in Ireland, on most measures, and so the government does not have huge spare resources to spend on the rebuilding of the affected areas.  Furthermore Japanese banks hold large amount of shares in other companies, and share prices have been falling.  There is a possibility (though a small one) that the banking sector might need government funds to strengthen their balance sheets, if the equity market continues to fall.   Bringing all this together, we believe that the impact of this dreadful event on the outlook for the global economy is quite small, and confined to a short-term loss of output in Japan, price rises for certain products and commodities, and short-term shortages of some items.  For Japan, the short-term impact is obviously far more negative than for the rest of the world, as production is disrupted across the economy, but statistically growth will benefit from the rebuilding in the affected areas from (say) the summer onwards.  However, there remain significant risks, so while our main macro forecasts remain unchanged,  the risks to those forecasts have significantly increased.   Portfolios Investment portfolios will typically have a relatively limited exposure to Japan, but of course they will be impacted in different ways and by different magnitudes, depending on their exposure to Japanese equities, to companies with significant dependencies on Japan, to nuclear power companies, to insurance companies, and to commodity prices, among other factors.  There will also be some companies who will potentially gain from this crisis, including for example renewable energy companies (as the future of nuclear energy is challenged, increasing the relative attraction of renewables).    While it is hard to generalise across our various portfolios and strategies, in general the direct impact on our portfolios is low.  Less than 2% of our Pension Managed fund, for example, is invested in Japan, although certain other portfolios would have a higher weighting.   There are of course other potential areas of impact.  For example, companies selling to Japan may see a reduction of sales, at least in the short-term.  Profit margins may fall for some companies if their raw materials costs rise due to supply shortages.  Insurance companies, including those outside Japan, may be hit by large claims.    On the other hand, some companies will benefit, including for example renewable energy companies, who may benefit as the future of nuclear power is challenged.    We continue to monitor all of these developments and their impact on our portfolios.

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It is that time of year again when I look into my crystal ball and think hard about the year ahead. While 2010 has been a volatile and at times turbulent year, in the end it was a very positive year for markets, with world equities up approx 11%, in local currency. This followed a 27% gain in 2009. Our central thesis for 2010 was that the sustained but bumpy global economic and market recovery would continue and that this would be positive for equity market returns – and that’s indeed the way the year panned out. Momentum to continue into 2011 Our base case is for more of the same positive returns in 2011, and especially during the first half. For the developed economies, the tone of economic data should continue to improve as the recovery builds, while monetary policy will remain supportive. The US Federal Reserve has recently embarked on a new round of quantitative easing and with the recent extension of tax cuts and other tax breaks by Congress, America is pumping itself with further stimulus steroids. In contrast to America, fiscal austerity programmes and banking instability in Europe will ensure that the ECB will keep rates low and for longer than it may ideally wish, with this particularly the case when the surprising strength in the German economy is considered. Emerging markets have been the engine of the global economic recovery and powered ahead further during 2010. From a micro perspective the excellent shape of the corporate sector (ex the financial sector) has been a constant positive through this recovery. The corporate sector learned its lessons during the previous downturn in 2000, keeping an unrelenting focus on maintaining low debt levels, high free cash flow, a ruthless focus on costs and delivering strong earnings and dividend growth. I expect this to continue in 2011, although the pace of earnings growth at a global level will slow to +12% from +20% or more in 2010. The second half of 2011 could be tricky I expect the second half may be a tricky and possibly a negative one for market returns, as markets worry about rate rises which historically cause market nervousness. Much of the recovery to date has been driven by unprecedented measures by governments and central banks across the globe. At some stage economies and markets will have to “stand on their own” again. Bearing this in mind, although emerging market economic momentum is expected to continue, a trickier period may ensue for the simple reason that the authorities in emerging economies will have to impose significant tightening measures such as further interest rate increases or restrictions on capital flows to slow down their economies. Such tightening of interest rates will undoubtedly cause a market setback as investors will fret about whether THE engine of global growth will slow too much. It is also quite possible that in the second half of 2011, markets may start factoring in rate rises in economies such as the US, UK or Europe in 2012. This may seem unbelievable at this stage, given current negative newspaper headlines, but the lesson from recent years has been to “expect the unexpected”! The risks Undoubtedly the largest obvious risk to the immediate market outlook is the ongoing systemic challenge to the euro, with the immediate challenge focused on Spain. Our central scenario is that Spain will not default, but undoubtedly further market volatility is likely to emerge during the first quarter.  Spain and other countries are making progress in relation to their deficits and banking systems, although they will undoubtedly have to enforce further more material austerity measures during 2011. Another risk, and one that many commentators are arguably overlooking, is that investors in the US bond market increasinly worry about the US debt and deficit levels, and attack it with similar gusto as has been unleashed on the Euro area over recent quarters. In many ways its fiscal situation is not much different to Europe’s, but to date “confidence” in the US has been stronger. Yet confidence as we well know is a fickle thing! While most analysts and the media headlines continue to obsess about downside risks such as that of double dip, there is a risk that the US economy continues its recent positive momentum and that it surprises on the upside. This would push bond market yields higher and call for the Federal Reserve to tighten rates sooner and could also lead to continued commodity strength such as the oil price hitting $100 per barrel. The big story…. I believe the big story during 2011 is likely to be the corporate sector as confidence builds in the sustainability of the global economic recovery . Non-financial-sector balance sheets are in excellent shape with very low debt and abundant cash reserves. With record levels of free cash flow building, we can expect companies to focus on how to use their cash as the cash will soon start to “burn a hole” in their pockets. I expect that we will see a less defensive mindset emerge and see increased dividends and share buy-back activity. I also expect to see a major acceleration of merger and acquisitions, and anecdotally over recent weeks we already have seen increased takeover activity in several of our portfolios. In summary, I remain cheerful into 2011. The global macro situation despite its many challenges is still positive and policy is supportive. Equities and other alternative risk assets such as commodities continue to offer an attractive risk-reward trade-off. Equities should post local currency returns of high single digits or possibly low double digits. Government bonds suggest all risk and no reward to me: with yields close to lows of 50 years or more they are very vulnerable to losses. At KBI Global Investors, we continue to manage your portfolios in an active manner and believe 2011 will possibly be a year of two distinctly different halves, requiring dynamic portfolio management. We believe it remains a more favourable environment for real assets over monetary assets. In an environment that will remain uncertain and volatile we emphasise the value of diversifying your portfolios. In your equity portfolios, the approach to stock selection will continue to emphasize quality and financial strength as winning strategies. With less earnings growth available in 2011, dividend yield and dividend growth will continue to grow in importance and be a winning strategy. Whilst the policies of governments and central banks have been the dominant drivers of market direction during 2010, I believe that the actions of the corporate sector will be possibly the major story for 2011.

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This Budget will reduce the deficit by about €6bn , yet Ireland will still have a deficit of about €18bn next year.  In those circumstances Budget 2011 needed to have credibility, to be capable of implementation even after a change of government, to avoid the use of accounting tricks or once-off measures, and to minimise the risk of depressing growth so far that the onset of an economic recovery recedes further.  On the whole, it seems to have met those objectives, although the banking system and the political system remain the great unknowns.   The main measures in the Budget are described in a separate note.   So the most-feared Budget in a generation has finally been announced.  And there was very little in it that came as a surprise, given that the key features were first announced in the National Recovery Plan two weeks ago, and then reaffirmed when the draft agreement with the IMF/EU was published by the government last week.  Social welfare rates have been cut, income taxes have been raised, capital spending has been decimated, and day-to-day government spending is being trimmed.   In macro terms, the deficit will fall to 9.4% of GDP, or €18bn, from this year's astronomically high level of 32% of GDP, although this year's figure is of course inflated by the cost of the bank rescue.  The overall package is about two-thirds expenditure cuts, and one-third tax increases, and is about twice the size of the package in the last Budget.   After these measures, government spending next year will be about €57bn, while total revenue will be €39bn, leaving a budget deficit of €18bn.  In 2011, the state will spend about 1.5 euros for every one euro it collects.

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The principal measures in Budget 2011 are listed below (see separate note and blog entry for a Budget Commentary).    In macro terms, the deficit will fall to 9.4% of GDP, or €22bn, from this year's astronomically high level of 32% of GDP, although this year's figure is of course inflated by the cost of the bank rescue (without the bank costs, the deficit was 11.6% of GDP).  The overall package is about two-thirds expenditure cuts, and one-third tax increases, and is about twice the size of the package in the last Budget. Of much interest to pension fund trustees and members, the Government has announced it will  go ahead with a scheme where Irish pension funds would have the opportunity to invest in Irish government bonds and to price their liabilities to pensioners on the basis of Irish, not German, bond yields.  This is a very technical measure but will come as extremely good news for Irish pension funds. Personal income tax credits and the standard rate tax band are being cut by 10%, bringing middle-income earners into the higher rate of tax at lower income levels.For a married couple, both of whom work, this will see an increase in the tax bill of €720.  Where they earn more than €65,600 between them, the cost will rise by another €1440. The two income tax rates of 20% and 41% remain unchanged. The income levy and the health levy have been merged to form one “Universal Social Contribution”.  This will be payable at 7% for income in excess of €16,000 per year.  The total top marginal rate of tax and levies will therefore be 52% (income tax 41%, PRSI of 4%, and universal social charge of 7%), which is unchanged.  PRSI and the new universal social charge will be payable on employee pension contributions, for the first time.  The annual earnings cap for contributions purposes will be reduced to €115k from €150k.

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Last night's announcement of the details of the EU/IMF support package contained some elements that were as expected, but others that were genuinely surprising.  The key issue now is the reaction of depositors.   Key Features: The package will total €85bn.   Of the total, €35bn will be used to support the banks, and the remainder is to finance the Government's own requirements.   Ireland will itself provide €17.5bn of the total, from existing cash reserves and the National Pension Reserve Fund.    The EU and EU governments will supply two-thirds of the external amount of €67.5bn, and the IMF will contribute the other one-third. The average interest rate on the €67.5bn being borrowed, if it was all drawn down today, would be about 5.8%  That's about as expected, and is in line with the average interest rate assumed in the National Recovery Plan published last week.   The loans will on average be for 7.5 years (longer and therefore more expensive than the three years that Greece borrowed for). €10bn will be used to 'immediately' recapitalise the banks, and another €25bn is contingent funding available for the banks if they need it over the next three years. Excluding Anglo Irish Bank and Irish Nationwide, the four other banks will have to have a core "Tier 1" capital ratio of at least 12% within a few months (up from the old 8% target), and this and other measures together mean that the banks now have to raise an extra €8bn in capital, over and above the amounts they had already been told to raise (about €5bn).  Presumably this extra €8bn will in practice all come from the €10bn set aside in the overall package for immediate recapitalisation, although Bank of Ireland stated last night that it would seek to raise the €2bn it needs from other sources. The four banks will be examined again in March, at which time external independent assessors will look at the asset quality in the banks.  If there is a risk at that stage that their capital ratio might fall below 10.5% in a stress scenario, they will have to raise still more capital then. The four banks have been given until the end of April to sell more non-core assets to reduce the amount of capital and liquidity that they require.  The Government will, if necessary, provide 'credit enhancement' to assist with the sale.  In essence this probably means that the Government will indemnify buyers of those non-core businesses against certain types of losses in the future. Land and development loans between €5m and €20m will after all be transferred to NAMA (losses on these loans were taken into account in calculating the total amount of capital the banks require). This all means that AIB will need €10bn in capital by February, Bank of Ireland will need a little more than €2bn, also by February, and EBS will need about €1bn by December. Irish Life and Permanent has until May to  raise a more modest €0.24bn.  These are the NEW totals: these banks had already been told that they needed to raise about €5bn between them. The capital required for Anglo Irish Bank and for Irish Nationwide was not announced, presumably as their restructuring plans have not yet been approved by the EU. Senior bank bondholders will not be affected, as it was agreed that to make senior bank bondholders take a hit would destabilise the European banking system. Ireland will now be allowed an extra year to get its deficit down to the 3% of GDP target, if required.  So the target year moves out from 2014 to 2015.  This is quite significant as obviously it gives some leeway if economic growth turns out to be somewhat slower than expected (a genuine concern for the financial markets).   How Much Will This Cost? Of the €67.5 Ireland is due to borrow, about €50bn was due to be borrowed anyway over the next three years, to finance the deficit and maturing debt. So for that €50bn, the cost, if any, is the difference between the 5.8% that Ireland will pay, and whatever rate it would have paid if it had been able to borrow the money on the financial markets.  At the moment that latter rate would arguably be considerably higher than 5.8%, so there is no extra cost on that basis.   The remaining €17.5bn can be broken down into an amount of €5bn which will be drawn down immediately to recapitalise the banks, and another amount of €12.5bn which may or may not be needed, depending on whether the banks turn out to need the money.  If it is all needed, the cost of €17.5bn at 5.8% is about €1bn p.a. In addition to that, of course, Ireland will lose whatever interest it now gets on its cash reserves, but that's likely to be quite small.   As an aside, it is conceivable, if by no means certain, that the capital that the state is putting into the banks could begin to earn dividends and/or rise in value over some years, if the economy returns to reasonable growth and the banks eventually return to profitability.   Will the immediate €10bn for the banks, plus an additional €25bn in contingency funds, be enough to properly capitalise the banks? A: The amounts that the four banks need in capital are calculated on the basis that all four need to have a core equity capital of at least 12%, and in addition that even in a stress scenario they maintain core capital of more than 10.5%.  That compares well with other European banks, and of course there is another €25bn of standby funding if they need to get even more capital than that.  So if markets, and depositors in particular, are rational, the €35bn should in fact be more than is needed to stabilise the banks, from a capital point of view.  (One caveat though is that it isn't clear whether any of the stand-by €25bn might be needed for Anglo, in which case the amount available for the four main banks will decline).   Q: If the banks have more than enough capital, does that solve their problems? A: Not necessarily.  Banks have to address their shortage of liquidity as well as their shortage of capital.  And liquidity is a real problem for the banks as they have seen depositors withdrawing funds on a large scale in recent months.  The ECB and the Central Bank of Ireland have stepped in to fund the resultant shortage of liquidity, but it is very clear that the ECB is uncomfortable with doing this, and would ideally like to reduce the banks' dependence on this emergency funding, which probably amounts to about €100bn at the moment.   This means that how depositors react to this package is absolutely crucial. Will depositors look at the huge amount of capital available to the Irish banks and conclude that they are among the world's best-capitalised banks (taking account the €25bn of stand-by funding), and therefore perfectly sound banks with which to place deposits or lend funds?  If so, liquidity will return to the banks and they will be both well capitalised and liquid.     On the other hand, depositors could just take the view that there are plenty of other banks to deposit with, which don't have any question marks at all,  and so continue to avoid Irish banks. If so, the banks will be well capitalised, but not very liquid, and ECB emergency liquidity funding will have to continue for a long time, and perhaps even have to be expanded - if the ECB is willing, of course.   At this stage it is just not possible to determine how depositors, and particularly international depositors will react.  But certainly we will all be watching this very closely.   Q: What about the €50bn for the Government's own financing needs, will this be enough? A: If future deficits are as expected, the €50bn amount would be enough to finance Ireland's deficits, plus bond redemptions, for the next three to four years, so yes it does appear to be enough.  Of course, if economic growth turned out to be far lower than expected the deficits would be larger, so the money would not last as long.   On the other hand, of course, if the Government can return to the bond markets at any point in the next couple of years, it would not require all of the €50bn, as would also be the case if economic growth was much higher than expected.   Q; When will the Government be able to, and want to, borrow from the bond markets instead of the EU/IMF? A:  Presumably the government will try to borrow from the markets as soon as something like normality returns to the bond markets, or in other words when (if) the Irish bond yields returns to 6% or below.  It's safe to assume that the authorities here would far prefer to borrow in the normal way from the markets rather than rely on this emergency package.  But there is of course no way of knowing when that might be. Q: What is the single biggest risk to this plan?

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Ireland’s formal application for EU/IMF assistance is a historic development, and today's Green Party call for a general election is a further significant though not totally unexpected move. Below I answer some of the most commonly asked questions about the package and today's developments.   Q: What are the implications of the Green Party's call for an election in January?    

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The Government has this morning announced that the current bank deposit guarantee, due to expire at the end of the year, will be extended at least until June of next year. The Government also said that in practice it wishes to extend it to the end of 2011, but under EU rules it can only get permission to extend for six months at a time.

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Roadmap

By Eoin Fahy  | 0 comments
If Ireland is to be able to borrow the €15bn or more gap that will exist next year between total spending and total income, the Government needs to pass several tests in the weeks ahead. In each case, it seems likely that the test will be passed. But the Government needs to pass each and every test to stave off the need to call in the IMF and the EU.  The next four weeks are crucial, and among the most important in the history of the State.   The Irish authorities could be forgiven for thinking that they have a bad case of déjà vu. Just over a year ago the markets, and the Government, were looking at the following issues, each and every one of which needed to be dealt with successfully if the markets were not to react very badly:  The Green Party and Fianna Fail had to conclude very difficult negotiations about a renewed Programme for Government. Assuming that agreement was reached between the negotiators, the deal still had to be passed - by a two-thirds majority  - at a special Green Party conference. The same conference was voting on NAMA, and many commentators expected that the Greens might vote NO to NAMA, throwing the government’s plans to deal with the banking crisis into chaos. Assuming the Greens signed up to NAMA (by no means a certainty), the legislation also had to pass through the Dail. Again this was no sure thing given the opposition to NAMA among government backbenchers and independents. Even if all that went to plan, the Government would next have to move on to the 2010 Budget, and produce about €4bn of cuts and tax increases, including very significant cuts in public sector pay – again. Could this pass through the Dail? Would the cuts be big enough? In the event of course, all five issues above were dealt with, the bond markets remained open to Ireland, and the economy survived.   But a little more than one year on, we are again faced with a series of issues that must be dealt with in a relatively short period of time, and this time the crisis is far worse, as indeed the bond markets are arguably already closed to Ireland, and the size of the required cuts is much larger.   (Note: In this commentary I concentrate almost completely on what the bond markets want and expect. There is of course an entirely different debate which could be had about whether the bond markets are right in what they want, either from a social or economic viewpoint. But to some extent that is becoming irrelevant – as Ireland can’t possibly finance its enormous deficit, if it can’t persuade the bond markets that it is doing the right thing, it will end up calling in the IMF and EU who will almost certainly insist on doing what the bond markets want anyway).   Let’s take a look at this autumn’s list of “To-Dos” for the authorities. The first test is, or rather was, to announce the total size of the cuts required over the next five years, and much more importantly the size of the ‘adjustment’ required next year, as well as the detailed economic forecasts behind those plans. That announcement was of course made last Thursday, and while the market reaction was not particularly positive, it certainly was not negative. The Government announced that the total amount of cuts required over four years is €15bn, and the amount to be cut in 2011 would be about €6bn. Next up is the “four year plan”, to be released some time later this month. This is perhaps the least clear of the various announcements, as we really aren’t very sure what it will contain. We already know the size of the cuts to come, and how much will come in 2011, and the economic forecasts for the next four years. We also know that traditionally the government keeps the really detailed measures with regard to tax and spending until the Budget. So what is left to be announced in this four year plan? Well it’s hard to know  – but we do know one thing for sure. If there is any sign of slippage or uncertainty in the government’s plans, the markets will react in a very adverse fashion, and very quickly. So whatever is in it, it had better be convincing!  In the last week of November comes the Donegal by-election. Normally an economic commentary such as this one wouldn’t need to comment on a by-election, but it becomes very relevant given the tight voting situation in the Dail. The Government currently has a Dail majority of three, which would fall to just two if it does not win the by-election. And of course no sitting government has won a by-election for almost thirty years! Arguably, however, as the Government is not really expected to win the by-election, there may not be much reaction on the financial markets if indeed it is lost. On the afternoon of December 7th the Budget will be delivered. We know that it will contain around €6bn of ‘adjustments’, with the bulk of them being spending cuts and the balance being increases in tax. So what will the markets be looking for in the Budget? Certainly they will want to see that the six billion is realistic, and not based on one-off accounting tricks or overly-optimistic economic assumptions. But they will also want to be sure that the cuts are carried out in a way which will have the least negative impact on economic growth. After all, there is no point in reducing the deficit by six billion only to have the economy decline so far as a  direct result that the deficit actually rises despite the cuts. The markets would prefer the tax increases to be implemented by means of eliminating loopholes and exemptions, for example, rather than by raising marginal rates of tax. They probably also favour a property tax rather than higher income tax rates, again because higher income tax rates tend to slow economic activity and thus collect much less tax than forecast, while property taxes are generally believed not to be as negative for economic growth. Late in the evening of December 7th, the first votes on the Budget will be taken, with the exact subject matter of the first votes dependent on various technical factors. Assuming the Government loses the forthcoming Donegal by-election, its Dail majority will be just two votes. So if any two backbenchers or independents can’t stomach the six billion of spending cuts and tax increases, and vote against the budget, or if any three abstain, the Government and the budget falls, and there would be a general election between three and four weeks later. Remember that under the Constitution, a government MUST immediately resign if it loses a budgetary vote. [Of course this parliamentary arithmetic assumes that all opposition parties oppose the Budget, which seems very likely].  So here we are again. Five major steps on the roadmap for “bond market survival”, and five steps that must be taken if Ireland is to avoid the need to approach the EU and the IMF for emergency financial support.  And these are only the immediate and obvious challenges of course - even if Ireland gets past the next four weeks, there are still any number of external or internal factors tthat could still go wrong sometime between now and next Spring, when Ireland hopes to re-enter the bond markets.

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The Government has just published the much-awaited outline of the size of budget cuts to come in next year's Budget, and beyond.  The headline is that €6bn of spending cuts and tax increases will come next year, with another €9bn over the following three budgets.  Together, this is planned to bring down the deficit to 9.5% of GDP in 2011, and 3% of GDP by 2014, as required by the EU. 

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QE2 in Choppy Waters

By Noel O Halloran  | 0 comments
As we enter the final quarter of the year, the volatile but positive global economic and market recovery that we expected for 2010 is very much on track.

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At the IAPF Annual Benefits Conference this morning Eamon O’ Cuiv, Minister for Social Protection announced the extension of the end November 2010 deadline for submission of funding proposals for underfunded DB schemes to the Pensions Board to an undefined date.   He also indicated that he would be working to push through legislation by July 2011 to introduce a new DB model as outlined in the National Pensions Framework (see below extract).   The proposal to overhaul DB legislation and introduce a new model by July 2011 is very ambitious, not least because of the sketchy nature of what was outlined in the Framework. In reality the extension of funding proposals and proposed introduction of a new model will mean most DB schemes will now take more time before determining how to restructure to eliminate their pensions’ deficits. The news of the extension was greeted positively by practitioners on the basis that, had the deadline remained intact along with current funding requirements, many viable DB schemes may have had no choice but to significantly reduce benefits or even wind up.     Extract from National Pensions Framework on future DB Model   5.6.2 Future of DB Provision The Government recognises that there are significant problems with the typical current design for funded DB schemes. This design has proven to be too inflexible to deal with recent investment losses and with increasing life expectancy and, as a result, increasing numbers of employers are considering the sustainability of their DB schemes. DB schemes are very beneficial for individuals due to the certainty they can provide and the fact that individuals are not required to make investment decisions. For these reasons, it is hoped that the measures introduced to support DB schemes recently will ensure the survival of this type of pension provision. However, it is recognised that in some circumstances, more significant re-structuring may be necessary in order to secure the viability of a scheme. Changes to schemes are, of course, a matter for negotiation at scheme level between employees, unions, trustees and employers.   However, the Government considers that where trustees are considering a radical restructuring of a scheme, the design set out below might be appropriate:  Fixed contribution rates for members and employers; Because contribution rates are fixed, benefits must be flexible in the event of investment losses or other adverse experience; and The benefit design must accommodate increases in life expectancy.  One possible way in which DB schemes could be re-structured is outlined in  5.1.   Such a structure could also offer a potential solution to overcome the structural difficulties currently associated with existing DB schemes. It would seek to address the drawbacks of the current approach while avoiding the excessive risk to which members of defined contribution schemes can be exposed. The re-structured scheme would consist of core benefits which would have to be guaranteed and non-core benefits, which would be flexible depending on economic conditions. This is not a hybrid scheme in the traditional sense as the non-core benefits would have to be secured in years of good returns, unlike hybrid schemes which only guarantee the DB element.   In reviewing the funding standard, consideration will be given to only applying the funding standard to core benefits where this type of design has been adopted.   5.1 Possible Outline of a Re-structured DB Scheme   Key Features Fixed contribution rates for members and employers; Flexible benefits (in the event of investment losses or other adverse experience); Increases in life expectancy accommodated in benefit design;  Benefit Level and Re-valuations Benefits would be expressed in current money. Each year, all benefits (current employees, former employees, retired members and other beneficiaries) would be re-valued equally, but only to the extent that the scheme could afford it.   In years of negative investment returns, little or no revaluations would be granted, while, in years of positive returns, trustees would seek to provide the revaluation that had not been paid in previous years. In setting the revaluation each year, trustees would be obliged to demonstrate that the rate declared was sustainable and consistent with the long-term viability of the scheme. The promised level of benefits would be significantly lower than under a typical current DB scheme but on the other hand, they would be provided to a greater degree of certainty.   Contribution Rates Contribution rates would be calculated on a basis intended to revalue benefits in line with inflation, before and after retirement. However, only these core benefits granted plus revaluations to date would be guaranteed, and this would be underpinned by regulation.   Benefits of this approach This suggested approach provides employers with certainty and predictability in their pension contributions. It also provides scheme members with a clearer understanding of the benefits that their scheme will provide them, and gives them a clearer basis for retirement planning.

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That Black Hole...

By Eoin Fahy  | 0 comments
What happened? Just a few short weeks ago, Ireland’s policies to deal with the fiscal crisis were being held up as an example to the rest of Europe.  But now Irish bond yields are hitting record highs, and the international media regard us as a pariah. The focus is clearly on the black hole that Anglo has become, but this is a mistake: the impact of Anglo on the annual budget deficit is actually quite small, relative to the overall budget deficit.

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Is the recovery over?

By Noel O'Halloran  | 0 comments
After a positive first quarter in 2010, the second quarter was a turbulent one.  The markets oscillated between “risk love” at the beginning of the quarter and “risk aversion” at the end of the quarter.  In April, strong equity markets and increased risk appetite were quickly pricing in a traditional “V” shaped economic recovery.  May, however, quickly became the opposite, as the markets rapidly moved 180 degrees to fear a relapse into a double dip global recession.  

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May Fire Drill!

By Noel O'Halloran  | 0 comments
In my most recent blog in April, I highlighted that the easy money had been made and that we expected a “tricky” volatile period for equities over the next 6 months. The month of May just ended was a negative and at times “scary” month for risk assets such as equities and commodities - a month that most dramatically challenged the positive tone of the previous 12 months during which we had seen a huge equity market rally, and one where the spontaneous market reaction was to run for the hills and seek safety in less risky assets such as gold and safe government bonds such as those of Germany.

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The Final Round?

By Eoin Fahy  | 0 comments
While many 'normal' people spent yesterday watching the final round of soccer's Premier League, rugby's Magners League and golf's Players Championship, financial market participants waited with bated breath for the outcome of what they hoped was another 'final round' of summit meetings in Brussels.  And the outcome was, for once, worth the wait.

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Greece Again

By Eoin Fahy  | 0 comments
A lot has changed in the financial markets since my last update yesterday morning.  At that time, markets had shown quite a muted reaction to the EU/IMF rescue package for Greece.  But from around lunchtime yesterday (Tuesday), the market reaction worsened dramatically.

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* The EU and IMF approved a joint €110bn funding package for Greece at the weekend, over three years. Although figures like that have been rumoured for the last few days, this was the first formal confirmation of the amount. * In return, the Greek government agreed a further €30bn package of austerity measures, involving de facto public sector pay cuts and another rise of 2% in the standard VAT rate, among other things. * The amount means that Greece will not have to raise any money from the bond market for at least two years, giving it a valuable breathing space. * The interest rate to be paid by Greece on the loan will be around 5%, far less than the market rate, where 10-year bonds yields are around 8.7% (two year: 10.8%, five year 10.5%) at the time of writing. * The money should be available for Greece starting next Monday (10th). * The ECB has, in parallel, announced that Greek government bonds will continue to be acceptable as collateral for its money market operations, even though its low credit rating might have excluded the bonds were it not for a change in ECB rules. * There has been a huge push on German parliamentarians to approve the deal, and now the legislation to approve the deal is expected to pass both houses of parliament on Friday. Nonethless, this is not a certainty and it remains the key remaining issue in the short-term. There is an important regional election in Germany on Sunday, so political tension is high around this issue. * The bond markets have of course improved, but remain nervous. Greek government bond yields are only back to where they were about ten days ago, and are still far higher than even, say, a month ago. Portugese ten-year bonds are now about 5.3%, vs about 4.2% a month ago, but 5.9% at the worst last week. Irish 10 year bonds now yield 5.1%, vs a recent worst level of 5.3%. * In contrast, equity markets haven't shown that much reaction. Since Friday, most markets are somewhere between down 2% and up 1% - a fairly normal range. * Bond market nervousness is probably based on the view that although the EU deal will certainly solve Greece's liquidity problem, it doesn't necessarily solve its more long-term solvency problem. Many - though not all - analysts still expect Greece to have to restructure its debt in the years ahead, despite the deal, as its debt burden is so big and its growth prospects so poor. But this is much more of a medium-term issue than one for the next few weeks, or even months.

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The first quarter was a positive one for most financial markets. As expected, it was also a volatile quarter, with positive and negative forces strongly to the fore in both directions, with the “good” finally winning out for the quarter. It is also worth noting that it’s now just over 12 months since the bear market lows of March 2009. The MSCI World Equity index rose by 9.6% in the quarter, and stood 67.7% above its March 2009 low, while the Merrill Lynch over 5 year sovereign bond index rose by 3.1% and 9.6% over the same periods.

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The theme of this year’s World Water Day, 2010 (Monday 22nd March) emphasises the risks surrounding both the quality and the quantity of water resources around the world.

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Further Market Gains in 2010, but expect Volatility.

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Today's Budget contained few surprises given the many leaks over the last few days.  Public sector pay was cut by €1bn, other current public spending including social welfare by €2bn, and capital spending by €1bn.  The deficit next year remains at a staggering €19bn. Key features of the Budget are listed below.  A comment on the Budget will follow shortly.

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The €4bn of savings in today's Budget are clearly necessary to begin the process of reducing the deficit.  But unfortunately this is only the beginning of a multi-year process, and we are faced with the prospect of another four or more Budgets as tough as this one before we get even close to budgetary balance.  That said, this was a genuinely encouraging start.

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Earlier today Reuters eTV carried a feature on the KBCAM Water Fund, including an in-depth interview with Craig Bonthron, investment analyst for the fund.  The interview can be viewed by clicking on the link below.

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Noel O'Halloran, Chief Investment Officer provides an investment outlook   The rolling 6 month returns since March are at historic record levels for European equities, gaining over 50%. The world equity index return of almost 15% (in euros) in Q2 was added to by a further rise of 12.8% (in euros) in Q3.

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One of the aspects of the NAMA announcements yesterday that has got little attention is the significant changes to the current bank deposit guarantee scheme.  The guarantee on all deposits will generally be extended for another five years.  But some bonds and other debt of the banks will not be guaranteed in future.

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NAMA: The numbers at last

By webtradeadmin  | 0 comments
Brian Lenihan, Minister for Finance, has just announced the long-awaited costings for NAMA.  NAMA will buy €77bn of problem loans and assets from the five affected banks, and will pay €54bn for those assets, a discount of €23bn or 30% on the value of those assets.  Five percent of the amount to be paid will be risk sharing payments. Both the total amount moving to NAMA and the amount being paid are somewhat lower (tougher) than expected.

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The report of the Commission on Taxation, of which I am a member, was published today.  Below is a list of the main recommendations related to pensions, and a link to the report. 

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The report of the Commission on Taxation, of which I am a member, was published today.  Below is a list of the main recommendations related to pensions, and a link to the report. 

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The Next Crisis

By Eoin Fahy  | 0 comments
Although turning points in economies are rarely noticed at the time, it is my view  that the recession in the US economy has ended, and that the recession in Europe will end soon (click here for a post on this topic). But economists now have to switch attention to the next major issue for the global economy. That issue is surely the generally accepted risk of significant global climate change and the very significant measures that governments around the world are, rightly or wrongly, implementing in response.

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The recession in the US is probably over.  Key measures of activity in the economy have recovered, and although some continue to fall, on the whole the economy is now expanding.  This does not of course mean that the US economy is set to boom - indeed there are good reasons to suggest the recovery will be slow - but it does mark a key milestone on the road back to normality for the global economy.

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Trends in corporate profit reports are helping stock markets.  But it's cost cutting that has improved profits, not better sales growth, and this has implications for the economic recovery.

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There are at least some reasons to think that the Irish economy may be moving in the right direction, and that if policy makers take the right decisions in the months ahead, a timeline out of this economic crisis could become clearer. The light at the end of the tunnel isn’t always an oncoming train!

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Our Chief Investment Officer, Noel O'Halloran, takes a look at the quarter ahead.  The title says it all: A brighter quarter, recovery begins and the bear market ends.

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Chinese Whispers

By Eoin Fahy  | 0 comments
Almost unnoticed, commodity prices have surged in recent months, which is quite a surprise given the still-weak economic conditions in the global economy.  As is so often the case these days, the cause of the surprise may be China, where growth expectations have been strengthening while the rest of the world economy weakened.

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Where It All Began

By Eoin Fahy  | 0 comments
The single most important thing to watch when deciding whether the global recession really is coming towards an end is probably the condition of the US housing market.  There are signs that US housing is stabilising, perhaps, but no signs at all that it is actually improving.  While the global economy is no longer flirting with Armageddon, neither is it already recovering.  We will have to wait a few more months for that.

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Barack Obama’s election brought much hope that the US would provide much needed (and long awaited!) support to combat Climate Change. He made clear his ambitious intentions from the outset and provided support for renewable energy and energy efficiency measures in “green” fiscal stimulus measures. However, two events last week (a Climate Bill in Congress, and a new national standard for car emissions) provide the most concrete evidence to date that the US has joined the critical efforts to reduce Green House Gas (GHG) emissions.  Steve Falci, our vice-president of sustainable investments, outlines these measures below.

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Today's announcement that the government is about to take various technical steps to help pension funds was just that - technical.  But it would be wrong to overlook this announcement for that reason.  One of the largest problems that Ireland faces is the huge deficits in private sector pension funds, and the announcement today could make a real difference to those funds.

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The First Swallow?

By Eoin Fahy  | 0 comments
A previous blog entry here asked, "Would You Recognise a Green Shoot of Recovery?". Today, for the first time in a long time, we saw some forecasts for economic growth being revised up. 

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Not surprisingly, the creation of the National Asset Management Agency (NAMA) is leading many people to ask about the "what, why, when, and hows" of this plan.  Only the Government has the full picture (maybe!) but below I set out what we do know, and what we don't (yet).

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There are four main criteria by which to judge this Supplementary Budget, in my view. Firstly, did it set out a credible, multi-year strategy for dealing with the dire state of the national finances? Secondly, did it take sufficient measures to address spending as well as taking the easy option of pushing up taxes? Thirdly, did it raise taxes, and especially marginal rates of tax, to such an extent that the economy will be badly damaged? Fourthly, did it lay out a credible plan to deal with the problem banks?

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Recent blog posts

Investment Outlook

Apr-6-2017
By klein(WB)  | 0 comments

The first quarter of the year delivered another strong quarter of returns from global equity markets, led by Emerging Markets and Eurozone. The strong returns were driven primarily by a combination of improving global economic growth fundamentals , continued 'hope' of further reflationary policies from the Trump administration, a lack of negative political events or market-shock events.

From here, I remain constructive on the outlook for global equity markets.

A significant change to highlight in this outlook is that after many years where I have singled out global central banks with their low interest rates and liquidity as the driving force for market returns, I expect that the next stage will see central banks take a step backwards as market direction will be driven by stronger and more sustained global economic growth and crucially by stronger earnings and dividend growth. Finally we get back to more self sustaining fundamentals!

While remaining 'glass half full' on the outlook from here, it's fair to re-iterate my continuous analogy of this now eight year old bull market as being a hurdle race rather than an easy sprint. To date investors have overcome each successive hurdle and in many cases not without much fretting. For coming quarters I highlight some hurdles that still lie ahead for us to monitor and negotiate such as:

  • Brexit negotiations will drag on for many months and could affect markets
  • French elections will loom large and possibly dominate for the second quarter.
  • The Trump administration’s policy agenda (after an unsettled first few months) will be front and centre over the summer.  Next up, tax cuts and infrastructure spending – both very important for markets, especially taxes.
  • President Trump has so far taken little or no action against countries that he views as trading unfairly with the US, including China and Mexico.  Will this change?
  • The US Federal Reserve will likely continue to raise interest rates, which is normally a negative for markets.
  • Inflation is picking up globally. While under control this far an 'inflation scare' would certainly unnerve bond and possibly equity markets. 
  • Ongoing global hotspots like North Korea – a particularly concerning example – can cause market concern from time to time.
  • A sudden unexpected slowdown in global growth is certainly not what I expect but can’t be ruled out.

Asset class outlook:

Equities

I remain constructive on the outlook for global equity markets underpinned by much improved fundamentals. I am particularly confident that 2017 corporate earnings growth will be meaningfully stronger than in recent years and that the upcoming first quarter earnings reporting season will be strong when compared to the similar quarter of 2016.

Stronger fundamentals and improved earnings growth should sustain a preference for value oriented stocks/sectors over growth oriented and benefit more economically cyclical sectors versus more defensive growth sectors.

The reality of Brexit will become a tougher reality as visibility emerges and decisions are made. Expect some more UK specific turbulence over the next 12 months with sterling vulnerable to further downside.

I note that in aggregate global equity markets valuations are now somewhat stretched and no longer fair value. There is, however, relative value across equity regions, for example I favour Emerging markets. I also believe that stronger economic growth emerging from the European economy has been overlooked by many investors. A 'market friendly' result from the French elections could be a catalyst for renewed appreciation of these improved fundamentals.

Elsewhere the corporate sector remains in a generally strong position with stronger earnings growth driving strong free cash flow generation. This is translating to higher dividend payments, increased buy-back activity and to an extent increased capital expenditures. The strong fundamental background of improving prospects and still relatively cheap money augurs well for continued Merger and Acquisition activity. 

Bonds

Global government bond yields have struggled now for the last few quarters and I expect they will continue to do the same. After many years of recording record new lows in what was best characterised as a deflationary environment, bond yields should continue to normalise to historic average yields (i.e. continue to rise) in this more confident reflationary environment. The threats of higher inflation, increased budget spending by certain governments and an upturn in the global interest rate cycle are all new headwinds to global bond investors.

To conclude, I remain positive on the outlook for global equity markets over the coming quarters. A more positive fundamental background will continue to challenge fixed income markets and I believe bond markets will continue to struggle to deliver positive returns. I highlight many challenges ahead that may cause temporary setbacks for equity markets. In general, consistent with this outlook I see such setbacks as opportunities rather than reasons to panic.

Noel O' Halloran, Chief Investment Officer, KBI Global Investors

KBI Global Investors Ltd. is regulated by the Central Bank of Ireland and subject to limited regulation by the Financial Conduct Authority in the UK. Details about the extent of our regulation by the Financial Conduct Authority are available from us on request. The views expressed above are expressions of opinion only and should not be construed as investment advice.

Investment Outlook

By klein(WB)  | 0 comments


Following on from a positive third quarter and spurred on by the Trump election victory global markets delivered strongly positive returns over the final quarter. KBI have characterised this current bull market as a hurdle race (one where there is constantly something to be concerned about) and the US election was another such fear during the quarter. Notably, 2016 will go down as a year where twice in a six month period, the world experienced a dramatic political outcome that completely caught consensus off-side. And equally twice in the same six months, global equity markets have not only survived the aftermath, but thrived which is the exact opposite of what the consensus would have expected. Another noteworthy event during the quarter was that global bond yields actually rose materially, reversing their previous bull market run to new historic lows. Have we finally seen the end the bond bull market?

We were modestly bullish on equities going into the fourth quarter and remain equally positive on a 12-18 month timeline. The US election result makes us more confident on the US macro outlook as we believe Trump’s more reflationary economic policies will continue to help equities and hurt bonds. The trends of Q4 should at least persist through the first quarter of 2017 coincident with President Trump taking over.

However, reflecting on the dramatic events of 2016 only serves to suggest that 2017 as a whole MAY possibly be an even more dramatic year and therefore a very volatile one for us to once again navigate through. Catalysts for potential volatility include:

• President Trump’s inauguration---headline risk’s abound and in particular in relation to ‘foreign policy’.
• The UK formally triggering Article 50 to leave the EU.
• National elections in The Netherlands, France during the first half of the year and Germany during H2. Nasty surprises?.
• The US Federal Reserve will most likely continue to raise interest rates.
• Any unexpected ‘shock’ events.

Our possible market scenarios for 2017:

1. Central case -muddle-through scenario

•The global economy does ok, led by the US which is likely to benefit from infrastructure spend and lower corporate taxes. Ongoing concerns about the Trump administrations foreign policies and election outcomes in Europe limit market upside. Government bonds generally remain under pressure as they worry about increased budget deficits, inflation and higher rates.

2. Best case scenario

•The Trump administration foreign policy implementation turns out to be far more balanced and benign than feared and delivers on domestic spending plans. Global earnings outlook is even healthier providing further strong upside for equity markets and even more pressure on bond markets.

3. Worst case scenario

•The Trump administration foreign policy implementation is even worse than feared and involves heavy import tariffs etc. Trade wars ensue and markets react very negatively. European election results may also end up with negative surprise results such as evidenced during 2016. Emerging markets in particular suffer.

Equities
Should do well in either of the more likely scenarios 1 or 2 above. Continued healthy earnings growth and strong balance sheets with generally still ok valuations underpin this upside.

Bonds

Global government bond yields are not far from historic low levels and in unprecedented territory driven by ‘lower for longer’ official interest rates  and central bank buying. A more confident world economy consistent with 1 or 2 is not positive for bonds and will confirm Q4 2016 as being the low point for yields.

Noel O' Halloran, Chief Investment Officer, KBI Global Investors

 

KBI Global Investors Ltd. is regulated by the Central Bank of Ireland and subject to limited regulation by the Financial Conduct Authority in the UK. Details about the extent of our regulation by the Financial Conduct Authority are available from us on request. The views expressed above are expressions of opinion only and should not be construed as investment advice.

Yesterdays winners eventually kill

By Noel O'Halloran, Chief Investment Officer  | 0 comments

 

Over recent quarters we have seen global equity markets hitting all time highs while at the same time there has been extensive media coverage of pension fund deficits blowing apart pension schemes. While they seem quite contradictory, both of course are correct because equity market levels affect the assets of a pension scheme, while its liabilities are calculated with reference to government bond yields – the lower the yield, the higher the liabilities. With government bond yields at historic low levels until recently, liabilities rose more quickly than assets, pushing up deficits to levels that in some cases have become unsustainable.

As a result defined benefit pension trustees are under pressure to buy government bonds. I strongly challenge this and indeed increasingly over recent quarters there are trends I highlight that are dominating thinking and investment flows that make me nervous:

  • The advice to de-risk pension schemes by selling equities to buy government bonds to reduce deficits
  • The move from active to passive equity management
  • Buying yesterday’s winners

This dominance of these trends make me nervous and lead me to the old phrase - “If everybody is thinking the same, then nobody’s thinking!”.  Just as trees don’t keep growing to the sky for ever, many market  ‘winners’  do reach a crescendo of hype which means that it’s time to get nervous and take action as an investor. Remember the great investment trends such as buying dot com stocks as they soared in the early 2000s, the move into Irish property during the mid 2000s and other such ‘winning’ trades? As we all know now, it turns out they were classic investment bubbles.

Thinking the unthinkable reminds me that this month, for the second time in six months, the world has seen a dramatic political outcome that completely caught consensus off-side. And for the second time in six months, global equity markets have not only survived the aftermath, they have thrived which is the exact opposite of what the consensus would have expected.

‘Thou shalt not worship false gods’ and so what about this recommended buying of government bonds — buying yesterday’s winners? Over recent weeks we have finally witnessed a material rise in bond yields and in my view there is a strong possibility that we have begun to finally burst the global bond bull market (bubble?). Will the election of Trump be recorded in the annals as the catalyst to burst the 35-year bond bull market?

Some arguments that make me believe that a further increase in bond yields is likely to happen include an increase in growth and inflation expectations and an increase in fiscal spending which will push up government borrowing.  It makes, in my view, much more sense for pension trustees to wait and see for a period whether these factors themselves reduce pension deficits via higher bond yields, rather than buying government bonds at their current, very expensive, levels.

It’s been a peculiar world since the global financial crisis in 2008, one where investors are constantly worried about something!  Nonetheless it has been a strong equity bull market, since the first quarter of 2009. This bull market has been a difficult one for many active asset managers who have struggled to beat their index and we have therefore seen a massive redirection of investor money towards indexed equity funds – again buying yesterday’s winners?

In my view the bull market has created significant valuation dislocations in large cap stock indices today. I believe strongly that buying the index is buying the highest risk and most inflated elements of the market right now. I remember active managers making similar anti-consensus arguments about technology stocks in the early 2000s and Japan in the late 1980s---they were right and I feel similarly today. Passive management is buying yesterday’s winners. Active management is aimed at buying tomorrow’s!

Noel O’Halloran, Chief Investment Officer, KBI Global Investors

 

 

KBI Global Investors Ltd is regulated by the Central Bank of Ireland and subject to limited regulation by the Financial Conduct Authority in the UK. Details about the extent of our regulation by the Financial Conduct Authority are available from us on request.

 

Eoin Fahy, Chief  Economist, KBI Global Investors shares his view following the announcement of the US Election results.

 

Although Mr Trump won by a very narrow margin in terms of total votes, the nature of the US electoral system is such that the Republican party now controls not only the presidency, but also both houses of Congress.  While markets are understandably nervous about the likely policies of the new President, and in particular his attitude to international trade, including existing trade agreements, the fact that one party controls all of the government should make it easier for legislation to pass, in sharp contrast to recent years when a divided congress made this extremely difficult. The relatively subdued response of the financial markets (at the time of writing) probably reflects at least some degree of optimism that the new administration will be able to significantly increase spending on infrastructure and reform the US corporate taxation system, again benefitting US businesses. It is also possible that a part of a possible corporate tax reform could include measures to encourage the repatriation of cash held overseas by US corporates.

Of course, the markets will be focussing on Mr Trump’s choice of key personnel (hoping to see experienced policymakers in charge of the Treasury and the State Department, for example,  as well as an indication of who Mr Trump would like to see heading the Federal Reserve when Janet Yellen’s term ends), and even more importantly will be watching closely to see if the new administration will follow through on his commitment to renege on international trade agreements and take a much tougher approach to existing, and new, trade deals. 

The president-elect’s policies on trade will be a key focus in the weeks and months ahead, in our view.  Mr Trump clearly favours new, and much more restrictive, controls on international trade, and for example, has said that he wishes to renegotiate the North American Free Trade Agreement (NAFTA).  It is not unusual for elected politicians, however, to change their views on key issues after they have been elected, and at this stage the markets do not seem to be expecting material, significant, and adverse changes to international trade.  If, however, Mr Trump really did press ahead with radical changes to NAFTA, or indeed unilateral withdrawal from NAFTA, this would most likely come as a significant and unwelcome shock to the markets.

The president-elect also spent a great deal of time during the campaign talking about China and trade, and making it clear that he would seek to restrict/penalise some types of imports from China, and also insist that China open up its markets to more US exports of goods and services.  Again, it is difficult to say at this stage whether he will follow through on his campaign rhetoric, but disruption to the arguably the most important trade flow in the world, that between the US and China, would clearly damage world economic growth and again would not be welcomed by the markets. 

In view of the importance of trade to the incoming president and to the financial markets, it is important to note that most legal experts agree that the US president has considerable legal powers in the area of international trade, and does not necessarily need support and/or approval from Congress in order to significantly change trade policy in many important respects.

A further issue for consideration, especially for the government bond market, is that Mr Trump’s policies seem likely to push up the US budget deficit.  This, together with higher inflation resulting from higher trade barriers and/or unskilled labour shortages due to immigration restrictions, should push up bond yields somewhat, which in turn might favour stocks with a value bias.

Our conclusion is that at this very early stage, it does seem clear that the election of Mr Trump will lead to higher uncertainty and a potential for significant change in economic policies, but it will take some time for markets to digest these changes.  Different segments of the financial markets are beginning to assess the impact of Mr Trump’s policies, if implemented, and as a result a period of considerable volatility and uncertainty lies ahead, in our view.  

 

 

 

 

KBI Global Investors Ltd. is regulated by the Central Bank of Ireland and subject to limited regulation by the Financial Conduct Authority in the UK. Details about the extent of our regulation by the Financial Conduct Authority are available from us on request. The views expressed in this document are expressions of opinion only and should not be construed as investment advice.


On a dramatic day for UK, European, and the global financial markets, Eoin Fahy, Chief  Economist, takes a look at the Brexit issue and in particular at five 'Myths’, that have arisen about what happens next.

 

Myth 1: As the UK is now set to leave the European Union, governments will now move quickly to introduce border controls on trade between the UK and the EU.

Reality: The UK’s vote to leave the EU is the start – not the end - of the exit process. It is likely that it will be late 2018, at the earliest, before the UK could legally exit, and it could in fact be considerably later than that. The exit mechanism in European law states that once the UK formally informs the EU of its intention to leave, under the terms of Article 50 of the European Treaty, a two-year period of negotiations begins, at the end of which the UK would legally leave. This period could only be extended by unanimous agreement of all 28 countries involved.  However, there have been some suggestions that the UK might opt not to invoke this particular article of the Treaty, as it puts inconvenient time limits and restrictions on the exit process.  Instead it may start a more informal set of negotiations to facilitate the exit.

Either way, however, it is very clear that barriers to trade between the UK and the EU will not be in place in the immediate future.

Myth 2: The European Union is falling apart.

Reality: The Brexit vote is a real blow to the EU, but it cannot be said to be “falling apart”. The fact that one country has voted to leave should be seen in the context of the growth (not decline) of the number of countries in the EU in recent years. Prior to 1973, there were only six countries in the EU. That grew to 12 in 1986, 15 in 1995, 25 in 2004, 27 in 2007 and 28 in 2013. The departure of one country, even the UK which is the third-largest member with about 13% of the EU population, does not mean that the union is falling apart. This is perhaps especially the case for the UK, which has always been seen as somewhat “semi-detached” from the EU, with much less enthusiasm for the EU at official and general public level than in most other EU member states.

To be fair, while it’s wrong to say that the EU is falling apart, it is not impossible to make the case that the UK’s departure could (note could, not will) lead to further departures over the next few years. The EU is unpopular in some countries such as Denmark, and the Dutch electorate recently voted against an EU agreement with Ukraine in a sign, perhaps, of its disaffection with the EU. In Greece, to date the electorate appear to continue to favour EU membership notwithstanding the extreme difficulties there, but further austerity measures and social unrest could change that picture. And there is always the possibility that the UK will lead to populist parties in other countries organising similar referenda, potentially with similar results. But this does seem unlikely at this stage, and certainly not a “done deal”.

Myth 3: Brexit will inevitably lead to a recession in the UK, and probably in Europe as well.

Reality: There can be little doubt that Brexit is negative for the UK economy, as has already been stated by a myriad of independent institutions and economists, inside and outside the UK.  But we need to be careful not to confuse “slow growth” with “recession”. A recession is a possibility; there is no doubt about that, particularly if the UK’s exit is badly handled. A scenario where negotiations failed to achieve an agreement to allow reasonably tariff-free access to each other’s markets could lead to a recession if it had a very negative effect on trade. 

But it’s much more likely that the negative impact would be felt over several years, keeping growth to a much lower level than would otherwise have been the case, and could well push up the unemployment rate, perhaps.

Turning to the impact on the rest of Europe, the negative impact on trade, and business confidence, is most unlikely – in its own right – to be big enough to cause a recession. While trade with the UK is important, the UK is just not important enough to cause a recession for a trading bloc as large as the eurozone. 

That said, a recession in Europe is nonetheless possible (though not probable) as a result of a different channel, i.e. a repeat of the European sovereign debt crisis. One conceivable scenario is that investors become concerned that other countries will leave the EU and it will eventually break up completely. In that scenario, weaker countries could no longer expect financial support from wealthy countries like Germany, or from the European Central Bank, and so in an extreme case they might be forced to default on their debts. 

Bond yields for peripheral, high-debt countries like Portugal, Greece, Spain and Italy would soar, and the damage to business confidence, combined with an inevitable credit crunch, would cause a sharp recession in Europe.

This scenario is unlikely and certainly not our base forecast, however.

Myth 4: The result of the referendum means that the issue is now closed. The electorate has spoken and the UK will certainly now leave the EU.

Reality: While it is certainly very likely that the UK will leave, it is not a certainty. As mentioned above, it will probably be at least two years before the UK could legally leave the EU, which gives plenty of time for UK and European politicians to reach an agreement on revised terms for UK membership of the EU, allowing a second referendum to be held, this time – potentially - resulting in a vote to Remain in the EU. We should not forget that a substantial majority of the members of the UK Parliament are in favour of remaining in the EU – approximately half of the ruling Conservative Party, as well as the considerable majority of the various opposition parties.

That said, a reversal of the decision would not be easy to achieve. Outgoing Prime Minister David Cameron has explicitly said that another referendum is not a possibility, and he or any other politician trying to overturn the referendum result could be seen to be defying the vote of the people, so they would need to be able to argue that circumstances have changed so much that a second vote is necessary.  This is possible, but unlikely.

Myth 5: Protest parties now dominate European politics.

Reality: It is easy to look at the UK electorate’s vote to leave the EU, combined with the strong showing of many other protest/populist parties across Europe, and conclude that these protest parties are about to take power in Europe. But the facts say otherwise. In the most recent general or Presidential elections, most of these parties obtained support ranging from about 15% to 25%. In Spain, Podemos took 21% of the vote in its most recent general election, while the Five Star movement in Italy got 26%, Syriza in Greece reached 35%, Sinn Fein in Ireland took 14%, the National Front in France took 18%, and the UK Independence Party (UKIP) took 13%. The exception is Greece, where Syriza took about 35% of the votes (but due to an unusual voting system, came very close to forming a majority government). These vote shares show a high level of support, certainly, but far below majority status.

The bottom line: populist/protest parties are now an important political bloc in many European countries, but they certainly do not dominate parliaments and they seem unlikely to take power anywhere other than Greece.

 

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KBI Global Investors Ltd. is regulated by the Central Bank of Ireland and subject to limited regulation by the Financial Conduct Authority in the UK. Details about the extent of our regulation by the Financial Conduct Authority are available from us on request. KBI Global Investors (North America) Ltd. is a registered investment adviser with the SEC and regulated by the Central Bank of Ireland. KBI Global Investors (North America) Ltd. is a majority-owned subsidiary of KBI Global Investors Ltd. 
IMPORTANT RISK DISCLOSURE STATEMENT
This material is provided for informational purposes only and does not constitute an offer to sell or the solicitation of an offer to purchase any security, product or service including any group trust or fund managed by KBI Global Investors. This introductory material may not be reproduced or distributed, in whole or in part, without the express prior written consent of KBI Global Investors. The information contained in this introductory material has not been filed with, reviewed by or approved by any regulatory authority or self-regulatory authority and recipients are advised to consult with their own independent advisors, including tax advisors, regarding the products and services described therein. The views expressed are those of KBI Global Investorsand should not be construed as investment advice. We do not represent that this information is accurate or complete and it should not be relied upon as such.  Opinions expressed herein are subject to change without notice.

 

The early weeks of 2016 were dominated by a very nervous and negative market environment, with headlines at the time being dominated by talk of the potential for global recession and persistent fears about deflation. The quarter ended on a much more confident note, with risk assets including equities rallying strongly and confidence restored in the global economic recovery and the health of the corporate sector. This ‘tug-of-war’ between for example; growth or recession, inflation or deflation, rate rises or rate cuts is something we as investors are now well accustomed to. As for outlook, we at KBI remain in the ‘glass half full’ camp as we have done since the global economic and market recovery commenced after the 2008 global crisis. Market volatility remains a constant feature as do the supportive actions of central banks, which once again came to the fore during the second half of the quarter. As such the first quarter of 2016 in many ways was a quarter of two halves, finishing on a more upbeat note. I continue to see equity market dips as a buying opportunity.

The more recent Federal Reserve comments have moved to reassure markets that interest rates would not be raised excessively, quickly or without regard to financial market fragility, have provided this strong underpinning to markets.  Meanwhile, the European Central Bank measures to boost bank lending and growth, including an expansion of its bond-buying programme, is also a positive. The central banks I believe will continue to support slow but steady economic growth. This growth while positive is unlikely to be robust at any time soon as we work through debt and other global overhangs.

Equities

As stated above, I regard market setbacks as an opportunity and not a threat. We are not as yet calling an end to the bull market that commenced during 2009 and I believe we have more years to run. A global economic and earnings expansion (albeit modest), supports higher equity markets from here. Equity markets in aggregate remain fairly valued and attractive versus other competing asset classes. 

During the latter half of 2015 and at the beginning of 2016 I highlighted material dislocations within equity markets and felt strongly these couldn’t be sustained. I highlighted the following dislocations which concerned us:

  • Growth stocks that were showing a significant outperformance over value stocks at magnitudes not seen since the early  2000s TMT levels.
  • I noted a major polarisation in relation to dividend yield, where for example in North America over the prior 15 months the lowest yielding quintile of stocks had outperformed the highest yielding quintile by in excess of 20%.
  • Significant industry group performance divergences. For example healthcare (biotechnology) and IT significantly outperforming industrial sectors.
     
  • The strong outperformance of Developed Markets over Emerging Markets.

These trends in all cases had resulted in major valuation gaps well beyond historic norms, which made us very uncomfortable.

At that point, I was anticipating a rotation from many of these extreme positions as I believed it would lead to a healthier overall stock market. Happily and interestingly there has been a relatively noticeable change in the first 5 months of 2016, with sector relative performance rotation; higher yield outperforming zero yielding stocks for example and a generally less defensive undertone helping value stocks and outperforming Emerging markets. We have also experienced a much better tone to commodity markets and to the surprise of many (not including us at KBI) a weakening dollar and some strength in Emerging market currencies. While the style shift year-to-date has been helpful, it has been modest from a mean reversion perspective, with potentially much more outperformance to be achieved from here I believe.

Fundamentals do always matter in the end and our concerns during 2016 was that in a risk-off/defensive mindset investors were almost investing for ‘growth at any cost’ and on the other side better valued companies or industries that were perceived as more pro-cyclical/less defensive were sold despite valuation. This is the big rotation I highlight year to date which can continue.

Meanwhile the corporate sector is in good health, with plenty of cash on its balance sheet and relatively little debt. A key driver for markets will be continued positive earnings growth over the next few quarters. I expect an increase in Merger and Acquisition activity, but also a focus on dividend yield and growth and other ways of returning cash to shareholders.

Bonds

Global government bond yields remain close to and increasingly in many cases below historic low levels.  A more confident world economy and increased inflation expectations over coming quarters should again not be positive for bond yields and I would expect yields to trend higher.

To conclude, I remain positive on the outlook for the global recovery and believe equities will continue to be beneficiaries of this. In contrast, while short term central bank behaviour is seen to underpin bond markets, I remain very bearish on a more medium term horizon.

Noel O’ Halloran, Chief Investment Officer 


KBI Global Investors Ltd. is regulated by the Central Bank of Ireland and subject to limited regulation by the Financial Conduct Authority in the UK. KBI Global Investors (North America) Ltd. is a registered investment adviser with the SEC and regulated by the Central Bank of Ireland. KBI Global Investors (North America) Ltd. is a majority-owned subsidiary of KBI Global Investors Dublin Ltd. This material is provided for informational purposes only and does not constitute an offer to sell or the solicitation of an offer to purchase any security, product or service including any group trust or fund managed by KBI Global Investors (North America) Ltd, or any of its affiliates, (collectively, “KBI Global Investors”). The views expressed are those of KBI Global Investors and should not be construed as investment advice. We do not represent that this information is accurate or complete and it should not be relied upon as such.  Opinions expressed herein are subject to change without notice.  

Markets remain extremely nervous with headlines at present being dominated by talk of the potential for recession and persistent fears about deflation.

For China which is the number one concern right now, we remain confident that despite delivering lower growth than prior years the economy will still deliver 6-7% GDP growth. Growth in the US and Europe remains reasonably solid with Europe expected to grow even more strongly than 2015 at close to 2% growth and the US is likely to deliver 2.5%. The US Federal Reserve will very slowly continue to raise their key interest rate over coming quarters. The ECB will maintain their very pro-growth stance having recently extended their QE programme. Commodity markets are friendless at present, but we do expect to see commodities bottom out as excess inventories are worked through in many global commodities.

Equities

After a relatively straight line bull market of six years since 2009, the current start of year market setback is not a surprise. Indeed many have been calling for this setback for some time. At KBI we regard this as a market correction and not a renewed bear market. We are not forecasting that the global economy will go back into a recession in 2016, which the markets are currently challenging.  Equity markets in aggregate look to be fairly valued.  ‘Inside’ the equity markets however, some major divergences have emerged over recent quarters for example:

Growth stocks are showing a significant outperformance over value stocks not seen since the early  2000s TMT levels
We note a major polarisation in relation to dividend yield, where for example in North America over the last 15 months the lowest yielding quintile of stocks have outperformed the highest yielding quintile by in excess of 20%
Significant industry group performance divergences. For example Healthcare (biotechnology) and IT significantly outperforming versus industrial sectors
The outperformance of Developed markets over Emerging Markets

These trends in all cases have resulted in major valuation gaps well beyond historic norms. We would anticipate and welcome a rotation from many of these extreme positions as we believe it would lead to a healthier overall stock market.

Meanwhile the corporate sector is in good health, with plenty of cash on its balance sheet and relatively little debt. A key driver for markets will be continued positive earnings growth over the next few quarters. We expect an increase in Merger and Acquisition activity, but also a focus on dividend growth and other ways of returning cash to shareholders.

Bonds

Global government bond yields remain close to or in some cases historic low levels.  A more confident world economy over coming months and quarters should again not be positive for bond yields and we would expect yields to once again trend higher .

To conclude, we remain positive on the outlook for equities in contrast to the current bearish and overly cautious consensus.

 

 

KBI Global Investors Ltd. is regulated by the Central Bank of Ireland and subject to limited regulation by the Financial Conduct Authority in the UK. KBI Global Investors (North America) Ltd. is a registered investment adviser with the SEC and regulated by the Central Bank of Ireland. KBI Global Investors (North America) Ltd. is a majority-owned subsidiary of KBI Global Investors Ltd. This material is provided for informational purposes only and does not constitute an offer to sell or the solicitation of an offer to purchase any security, product or service including any group trust or fund managed by KBI Global Investors (North America) Ltd, or any of its affiliates, (collectively, “KBI Global Investors”). The views expressed are those of KBI Global Investors and should not be construed as investment advice. We do not represent that this information is accurate or complete and it should not be relied upon as such.  Opinions expressed herein are subject to change without notice.  

Noel O’Halloran, CIO of KBI Global Investors got off to a flying start as an aeronautical engineer. The scientific approach this experience engendered has paid off in his current role.  By Mark Battersby

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Where to from here...can equity markets keep going?
Despite the strong returns achieved last quarter, for euro investors in particular, I continue to take the ‘glass half full’ view and believe that equities can make further progress over the next 12 -18 months. It’s worth highlighting that in absolute valuation terms, equities are no longer cheap, as the MSCI World equity index is now on a P/E ratio (using 12 month trailing earnings) of 18 versus the 16.9 times historic average, and so equities are now above fair value relative to history. My core expectation from here is that further upward progress will be in line with earnings and dividend growth rather than by further P/E expansion. The slow-but-sure economic recovery we forecast will support this.

I could go further and highlight that there is perhaps a 20% chance that equities continue to perform strongly and continue to rerate even further upwards to a P/E of say 20. In a world where many major central banks continue to make strong efforts to boost growth (and inflation) through Quantitative Easing (QE) and other means, bountiful liquidity continues to flow into the financial system which can first drive asset prices strongly upwards, with the real economy responding with a lag. That abundant liquidity has already had a strong impact on government bond markets – with many eurozone government bonds yields being below zero for periods out to 5-7 years, or longer in some cases.

Those low bond yields, and very low deposit rates (negative in many cases) also support equities as they make bonds and deposits, the traditional alternatives to equities, extremely unattractive relative to equities, particularly equity strategies with appealing dividend yields of say 4%.

Where can it go wrong.....the key remains growth?

This equity bull market is now six years old and probably one of the few in history where investors have worried the whole way up. For me there are no signs of exuberance, such as we saw for example during the ‘TMT’ bubble of the early 2000s, as for every positive I can highlight, there can be a corresponding concern or worry.

For me THE key issues to watch will be:

1)   The US economy.  Growth in the US has been quite weak during the first months of 2015 with events such as severe weather being blamed. A rebound is expected by the markets and by most economists over coming quarters. If this does not happen, it would be a material unexpected negative as the US remains THE engine of the global recovery. This would have negative implications for the earnings and dividend growth I highlight above.

2)   Chinese growth. The Chinese government has been directing and managing a slowdown in their economy, towards or slightly below the 7% growth level. This has been achieved without any significant dislocations to markets or society. Any further significant slowdown from here to say 3 or 4% growth would be a significant negative for global equities

3)   The impact of ‘QE’ in Europe.  An obvious issue to watch is whether the ECB's QE programme will bear fruit. It's early days but there has been a more positive tone and indeed an economic pickup in Europe over recent months. A relapse would be provide a meaningful challenge and, at the least, a meaningful setback to equity markets. Greece will also remain in the European headlines

4)   Market breadth in the US.  While I remain generally relaxed, I am not relaxed with what I perceive to be quite a narrow and unhealthy US stock market. Over recent months in particular the market has been hitting new highs but led by a very narrow list of stocks in high-momentum, high-valuation sectors such as biotechnology and new-economy technology stocks. Large parts of the market aren't participating in these new highs. I would look to see the leadership in the market rotate and broaden out over coming quarters as if it doesn't, for me it would begin to echo the early 2000s market which would not be positive.

5)   Strange bond markets! To fundamentally rationalise bond yields at current yield levels is pretty impossible. The distortion created by central banks buying is seemingly very apparent. When I see for example that Danish home buyers now get paid by their bank to take out a mortgage or the Mexican government launches a 100 year bond denominated in Euros at a yield of just 4%, it’s not normal. Similarly when I was told that wealthy Swiss savers are now taking the money from their local Swiss bank account and lodging it in security company vaults and paying them 15 basis points per annum for the privilege because it’s cheaper than the negative rates the banks are paying, it’s certainly not normal! At some point just as with the TMT bubble, this bond bubble will burst. To pinpoint when or how is the difficult bit.

To conclude, despite strong returns to date, equities remain the asset class of choice against pretty much zero returns on cash and bond markets which are fundamentally unattractive in our scenario. From a macro perspective, the main change we expect to see over the next couple of months is confirmation of improved growth and activity in Europe, where a combination of the lower euro, much lower energy prices, and QE by the European Central Bank is expected to boost consumer and business spending, as well as exports.  Other economies are also expected to grow at a reasonable rate.  Globally, we expect to see further cuts in interest rates, particularly in Emerging Markets, but in contrast US interest rates are likely to rise (for the first time in many years) in the autumn.

Meanwhile the corporate sector is in good health, with plenty of cash on its balance sheet and relatively little debt.  We expect an increase in Merger and Acquisition activity, but also a focus on dividend growth and other ways of returning cash to shareholders.  Against this background in our portfolio construction we continue to emphasise stocks with strong cash flows, attractive balance sheets and strong and attractively positioned businesses. In a world of zero or negative cash rates, I expect equities with attractive and growing dividends to remain winners. 

Noel O'Halloran, Chief Investment Officer

During 2014 we recorded new highs for global equity indices as well as recording the sixth year in a row of positive returns from global equities. This was achieved despite many headline challenges be they geo-political or simply the ongoing challenges of the muddle through growth struggle for many of the world’s economies. From my general perspective, this constant ‘barrage of challenges’ to the recovery scenario was to be expected and has been a feature of the global equity recovery since March 2009. Global bond markets have also continued to hit new highs confounding all negative predictions (including yours truly) once again.

For 2015, I believe we can expect more of the same, albeit with more volatility than recent years. While the global equities have been in a bull market now for six years and is therefore quite mature, I don’t believe the bull market is over but do believe investors should expect more modest single digit returns for 2015. The lesson from recent years have been that while ‘hits’ have been many and frequent they are transient and eventually overcome by improving fundamentals and central banks that keep the recovery underpinned....so buy the equity dips!

Why more modest returns?

  • The key reason is that equity valuations are no longer cheap and I believe that returns should be more in line with global earnings growth – which I expect to grow by 6%. Over recent years strong double digit returns were driven both by earnings growth and an upward revaluation of P/E multiples. Although this re-rating could continue, it’s not my central expectation. This also underpins my strong preference for high but sustainable dividend yields as a component of total return.
  • Earnings themselves have become more dependent on top line growth as the impact of significant margin improvements over recent years lessens. In a muddle through growth environment for many economies, robust top line growth is not to be expected
  • One key reason to expect higher bonds and equity volatility is that the Federal Reserve (Fed) will change course and commence raising US interest rates this year. The US itself has been a strong driver of the market and economic recovery and low US interest rates have underpinned this. We don’t expect the Fed will make a policy mistake but that’s not to say that markets won’t experience another one of their ‘transient wobbles’ when it happens

What will we be watching?

  • Top of the list over the first quarter will be the euro (again). Click here to see our separate blog of Jan 7 for our views re same  
  • The dramatic oil price fall of late has been a significant market feature. I expect the majority of the fall is now complete and my running assumption is that the oil price stabilises around current levels in a range, perhaps for a number of quarters
  • Global central banks have remained the bedrock of the global recovery and while the Fed may change direction in 2015, I don’t expect the global central bank underpinning to change. While much negative energy will likely be expended worrying about the Fed, a corresponding positive may emerge in the form of the ECB embarking on a more radical quantitative easing programme, the Bank of Japan continuing to stimulate and many Emerging Market economies may surprise with more stimulative policies (both fiscal and monetary easing).

What could surprise?

  • The markets to date have had a very nervous and negative reaction to the rapid oil price fall. They haven’t yet however put enough emphasis on the positive benefits of this fall.Over coming quarters, I expect we will see improved consumer spending, enhanced profitability in sectors such as transportation, and improved growth in countries (often Asian) which are large importers of oil. Lower inflation from lower oil prices will be written up as ‘deflationary’, but it is a benign deflation that actually benefits rather than hurts the beneficiaries. So while the damage to certain sectors such as oil stocks or countries such as Russia has been immediate, I think the beneficiaries haven’t yet been properly rewarded. Indeed, from our perspective many sectors with little direct exposure to oil have been severely overly-punished we would argue, and provide opportunity for investors.
  • At a regional level, having been hit with many concerns over recent years, Emerging Markets are increasingly off the radar of global investors.  I feel that they are becoming a forgotten asset class. Against a background of attractive valuations, reasonable fundamentals and a real possibility of interest rate cuts, Emerging Markets could be a surprise winner for 2015.
     
  • Another beaten up asset class for the contrarian investor to consider is broad commodity investments once more. They certainly could perform much better in an environment of increasing confidence surrounding global growth and a move to a more ‘risk-on’ environment. I’m not convinced at this point but perhaps one to revisit through the year.

To conclude, I believe that 2015 will be a positive year but one with more modest returns and with more volatility to be expected. Equities remain the asset class of choice against pretty much zero returns on cash and bond markets fundamentally unattractive in our scenario. Central banks will remain central actors on the stage, although their roles will change with the Fed likely to become more the ‘bad’ guy and the ECB and others to become increasingly centre stage. 

Noel O' Halloran, Chief Investment Officer


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