Author: admin@hottinger.co.uk
Corporate earnings take a turn for the better – Q4 2016
Values and money – What Future for Ethical Investment
By Seb Beloe, Partner, Head of Research at WHEB Asset Management
‘Give me a child until he is seven and I will give you the man’. So said Saint Ignatius of Loyola the principal founder of the Jesuit order, underlining that much of our character is formed at an early age and once formed is difficult to change. Today psychologists call this ‘cultural cognition’; a tendency of individuals to conform their beliefs to values that define their cultural identifies. People don’t change their minds much because what they believe is often connected to who they think they are.
How people think about ethical investment also tends to be rigidly set. For most financial professionals who normally pride themselves on their objectivity, ethical investment is a synonym for under performance. For them, the mere act of introducing moral considerations into investment decisions mean that you would be inevitably accepting that your portfolio as a whole will underperform.
This may or may not be true when such decisions are taken on a purely moral basis. But the key point is that for certain issues, including many environmental issues, decisions are no longer primarily about morality. Addressing issues like climate change, water scarcity and air pollution, are today much less about ethics, and much more about commercial, regulatory and technological considerations. Investing in a company that makes cleaner powertrain technology for cars clearly has a positive impact in helping to reduce air pollution. But the investment rationale for investing in such a business is that demand for these technologies is growing rapidly as regulators around the world force the car industry to clean up its act.
WHEB Sustainable Investment Themes
WHEB is an investment firm focused on investing in ‘positive impact’ businesses. We have found that companies that are exposed to key sustainability themes such as resource efficiency, sustainable transport, health and education have enjoyed much higher rates of growth than the market as a whole. Over the last five years, our research shows historical sales growth has been between 8-9% per annum for companies that fit these themes, while the rest of the market (as measured by the MSCI World) has delivered less than 5% sales growth. In a world that isn’t growing very much, this is a part of the market that is enjoying substantial and sustained growth.
So where does this leave ethical investment? Ethical investment emerged in response to specific moral concerns about certain industries. It was defined by what it didn’t invest in. But the world has moved on. The critical problems that society faces are around ageing, urbanisation and environmental issues. Free markets have responded with businesses developing new technologies and new business models that help solve these issues. Is this ethical investment? You could call it that. But it is also just good investment.
Investors need to take transition risk seriously
Last week, Blackrock CEO Larry Fink wrote a letter to CEOs calling for them to “serve a social purpose”. A key phrase reads:
“Society is demanding that companies, both public and private, serve a social purpose. To prosper over time, every company must not only deliver financial performance, but also show how it makes a positive contribution to society. Companies must benefit all of their stakeholders, including shareholders, employees, customers, and the communities in which they operate.”
He explicitly tied financial performance to meeting sustainability objectives:
“Your company’s strategy must articulate a path to achieve financial performance. To sustain that performance, however, you must also understand the societal impact of your business as well as the ways that broad, structural trends – from slow wage growth to rising automation to climate change – affect your potential for growth.”
When the man who oversees $6trn in assets says sustainability matters, the theme cannot really be regarded as a purely ethical activity.
I was in Zürich last week for the 2nd FINEXUS conference on Financial Networks and Sustainability, attended by leading practitioners, policy makers and academics. The purpose of the conference was to assess how sustainability criteria can be better integrated into the policies of central banks and development banks, the lending decisions of retail banks, and the portfolio decisions of asset managers.
If the forecasts for climate change are right, we are currently on course for irreversible environmental damage. We all know what this means: coastal flooding, water shortages, and lower crop yields; not to mention the effects on our oceans and for biodiversity. As the impacts of climate change will be concentrated in the Global South, we can expect huge intercontinental migrations that make the 2015 Syrian refugee crisis look like the tip of an iceberg.
The 2015 Paris Agreement commits countries to take action to limit the amount of global warming to 1.5C by 2100.
As Stanislas Dupre – member of the High Level Expert Group on the EU’s sustainable finance taskforce – explained at the event, the investment industry is funding a path that leads to warming of 4-6 degrees on the basis of its current choices, financing infrastructure that locks in emissions for decades to come.
Putting these two facts together means that investment managers who do not take sustainability seriously are likely to find themselves on the wrong side of transition risk in the coming decade. This is because commitments to the Paris Agreement make it highly likely that governments will regulate their economies to discourage and penalise carbon-intensive activities. It has almost nothing to do with the moral case for unilateral action and everything to do with the future tax, regulatory and legal changes made by governments which have committed to going green.
Asset managers who hold securities tied to carbon-intensive firms may therefore face significant losses. Huge amounts of capital need to be mobilised into green investments, and states committed to the Paris Agreement will take steps to facilitate this process. The ultimate risk that firms and investors face during the transition is being left holding stranded assets that have lost their value by either regulatory or technical changes.
There are other kinds of transition risk – such as the risk of a bubble in green assets – but the one that is immediately relevant for industry is the risk of stranded assets. This could plausibly arise in a number of ways:
- An announcement on a global (or national/regional) price for carbon
- New technological breakthroughs in the low-carbon sector
- The achievement of a price parity between renewables and fossil fuels
- Changes in legislation reflecting the legality of GHG emissions
- The forced nationalisation of selected assets
- An increase in pressure from shareholders, employees and activists to limit GHG
- Commitments to reduce implicit subsidies of fossil fuels (which are very large)
- An increase in accuracy in the monitoring and measurement of emissions for attribution to firms
- An increase in social awareness of the risk of GHG emissions
Any of these factors could affect the long-term return from carbon assets in portfolios.
The conference also hosted panels that discussed the need for stress-testing for climate and transition risk. This would be an activity that would help asset managers, central banks and development banks understand the possible consequences of the renewable energy transition.
This is a new area of research that could inform the policy of central banks in the future, especially when it comes to QE. If it is understood that carbon assets present a threat to financial stability as the effects of climate change on the economy take hold, central banks could make the case to favour ‘green’ assets (such as green bonds and companies that have low carbon intensity) when engaging in asset purchases.
A future Basel IV agreement could see rules that impose stricter capital requirements on banks that lend significantly to carbon-intensive activities. These policies could therefore reduce the cost of capital and increase its availability for green companies.
Other policies could have a similar effect. Mafalda Duerte from the World Bank’s Climate Investment Funds explained how state development banks could further raise the NPV of green activity by issuing green bonds that pay for subsidies and ‘credit enhancements’ to green firms.
Further, tax benefits could be offered to issuers of and investors in green assets, again with the aim of lowering the cost of capital as well as increasing the depth and liquidity of green asset markets.
These policies and others create transition risk for firms and investors, and they need to be assessed and quantified.
There is no immediate threat to existing portfolios but the message from the conference was that the status-quo will be costly in one way or another, and quite soon. Companies that invest for the long-term need to consider the issue of sustainability. There are opportunities as well as risks, and there will be returns for being on top of both.
A meeting with Michel Barnier
John Longworth sits on the Hottinger Group’s Advisory Board, was Director-General of the British Chambers of Commerce, and is a leading Brexiteer. Here, John writes in a personal capacity, and all views expressed in this piece are his alone.
If the latest reports from Berlin are to be believed the Germans are insisting on substantial payments in order that the City banks have “access” to the EU market.
It is not clear whether “access” means equivalence, in which case UK based banks are being discriminated against versus US or Japanese banks, which is outrageous; or something better, in which case it would be unprecedented for the EU and completely undermine Barnier’s position. It is clear that Barnier is being instructed to take a hard line in order that the Germans can mug us, if the reports are true.
We should bear in mind that while financial services contribute to the treasury they represent 8% of the economy, less than manufacturing. In addition to this, only 9% of financial services is subject to passporting; there is a Single Market of sorts in these services which represents just 0.7% of GDP. Of course there are additional professional services supporting this activity but we should not let the tail wag the dog and it is only worth so much. As for the rest of financial services or indeed Services in general, there is no single market in the EU do why should we expect to have “access”?
The government need to wake up to what is in the country’s interests and start to bat for Britain.
Meeting with Barnier.
It may have come as a surprise to some of my colleagues at the meeting with Barnier, but not to me, that the EU is determined to put the “EU project” ahead of the employment prospects and wealth of its citizens and, as a consequence, take a very hard line with the UK in the upcoming negotiations. The Gaullist Mr Barnier accepted my compliment that he had successfully won the first round of negotiations, albeit against a weak adversary in the form of the UK government. It was clear that he and his EPP (European Peoples Party) colleagues, who control all the major EU institutions, are determined that the UK should be shackled as much as possible in respect of our newly won economic freedoms in order that we may not compete with the EU.
The position of the Chief Negotiator is entirely rational and internally consistent if the “project” is key to the interests of the EU (and certainly to the chief EU paymaster, Germany) and it is vital that our government grasps this.
Britain has the prospect of prospering with or without an EU trade deal, provided we retain our newly won freedoms and are prepared to leverage these. The chances of a special arrangement for the UK are limited, so an early resolution of the likely outcome is essential if business on both sides of the channel is to have time to plan and implement necessary measures. Certainty on the direction of travel is more important than the outcome itself. I made these things clear to Mr Barnier and also that there is an increasing majority in the UK in favour of getting on and leaving the EU. Brexit is happening and Britain is determined to see it through.
Crucially, the meeting made it clear to me that the British government needs to adopt an equally tough line in the interests of our country, equal to that of the EU 27, and that will include an early view on whether a trade deal is likely to be forthcoming, with serious preparation for a no trade deal scenario. In any event the government must be prepared to leverage our economic freedoms to boost business and the economy, with or without a trade deal, rather than trying to preserve a poorer version of what we have now. which can only result in our being worse off. Preparations for this must start now.
Investing for impact without being an ‘Impact Investor’?
If you are feeling disillusioned with modern capitalism and would like to influence how corporations behave there are, essentially, four ways in which you can make a difference:
- Vote for political representatives who will create and maintain adequate regulatory environments and boundaries for companies to operate within.
- Vote with your wallet and consume only products and services that do not have unmitigated negative impacts on the environment or society.
- Control the flow of your excess capital through the banking system to fund only companies who behave appropriately.
- Invest only in companies that have positive impact and avoid investing in companies that have negative impact.
The influence of voting decisions and consumer choice is well understood, but investment is probably the most overlooked method of influencing a firm and may have the potential to be the most powerful.
Each time an investor decides to buy a share in a company, she is deciding to provide capital to that company. Companies thrive when their ‘access to capital’ is unconstrained and boards often focus more on this than anything else. From their perspective, while politicians are a nuisance and customers a necessary evil, capital is the king that can make their day.
In a wider context, every company has an impact on its stakeholders and surroundings. Some can be large. Most people are aware of the negative impacts. Large companies use significant chunks of the world’s natural resources and create massive amounts of waste. They use ‘tax minimisation strategies’, mislead their stakeholders with disingenuous PR, and use their capital to sway political processes in their favour. Companies that have a negative impact on society and the environment also create long-term legal, regulatory and financial risk for themselves, their shareholders, employees, partners, neighbours and others.
But companies can act as tremendous forces for good. They employ tens of millions of people, buy billions of dollars of local produce and provide basic services for the poorest people on the planet. They build infrastructure and develop innovative solutions that have the world-changing potential that we so desperately need. This potentially positive impact of large companies materialises only with flows of capital, which are influenced by each investment decision. These decisions may have a small impact individually but, when many investors act together, great changes can be achieved.
In recent times, many fund managers have ‘branded’ their funds as responsible, sustainable or ethical, without much external assessment or oversight. This has led to confusion amongst investors and a lack of consistency across peer groups. Impact-Cubed recently conducted an internal assessment of the ‘impact’ of 30 well known sustainable portfolios in UK using a proprietary methodology based on publicly available environment, social and governance data. Disturbingly, for the three poorest performers, the ‘impact’ score was actually negative. About 60% showed quite dismal results. Only ten funds were really delivering the impact they promise in their marketing.
In order for your own investments to have a more positive impact, we recommend focusing on three simple things:
- Consider the current impact of your investments.
The way you invest your wealth and assets that you control impacts the flow of capital to companies. Your long-term investment plan will not only influence the risk and return of your portfolio but your decisions impact on the wider stakeholder group affected by these companies.
- Ask your wealth manager to measure the impact of your portfolio
Look at your existing portfolio of funds and listed equities. Is it aligned to your view of the world? Are you knowledgeable of and comfortable with the impact it has? Do you feel sufficiently compensated for the additional risk that negative impact potentially has if you own companies which may be causing harm, such as tobacco or fast food companies? Could you perhaps set some targets together with your wealth manager to ensure you reduce that risk over time?
- Adjust accordingly
If you decided to reduce ‘sustainability’ risk in your current portfolio and it is not sufficiently aligned, some positions in your portfolio may need to be adjusted. While this might seem difficult and tiresome, after the adjustment you can rest assured. It is possible that you will have ‘future-proofed’ your investments’ risk and return. Furthermore, you did the right thing. Every investment decision towards positive impact makes the world a better place, even when you are seeking returns through listed equities and funds alone.
Guest contributors Larry Abele, Arleta Majoch and Antti Savilaakso are hedge fund managers who have been investing with impact for over 10 years. They recently launched an Investment Impact Measurement tool, Impact-Cubed, which enables investors to measure and manage the impact of their investment portfolios. An account manager can use the tool to help you understand the role of impact in your investment portfolio and to set targets for the future, if you desire. Details of costs can be found out on request.
Low global interest rates are the new normal
The global economy is in fine form. Recent figures tell us that in the last year the United States grew by 3.0%, the euro area by 2.4% and China by 7.0%. Growth in almost every significant nation has outpaced market expectations. The exception for now is India, which is still struggling with the fall out of Prime Minister Modi’s demontisation policy.
Despite favourable monetary conditions, inflation is below 2% in most developed markets and below 4% in most emerging markets. This has created a benign environment for global trade; for corporates, whose rising pricing power has fed through into earnings; and for risk assets, which have benefitted from low volatility.
We are not completely convinced that this positive moment for the world economy is sustainable and we have raised concerns about the lack of productivity growth in the G7 and the financial stability risks associated with easy money. Nevertheless, we think the outlook for both developed and emerging markets over the next 2 years looks relatively positive.
If productivity continues to disappoint, inflation will start to rise. If money stays easy for too long, financial stability tends to weaken, a particular concern of the Bank of International Settlements. A key question therefore for both economists and investors is – as ever – if, when and by how much will central banks raise interest rates. Central banks have a responsibility to manage both inflation and general financial conditions.
There are two different issues here. One relates to the nominal interest rate; the other refers to the real interest rate. Nominal interest rates remain in an exceptional place. Policy rates in Europe, Japan and the US are below 1.5%. Sukanto Chanda at Deutsche Bank has assessed the $8trn global credit market and finds that 17% of all sovereign and credit debt trades at negative interest rates. These positions depend almost entirely on central bankers’ monetary policies and are likely to reverse as soon as banks embark on a sustained course of balance sheet and policy normalisation.
But this leaves the question of how high interest rates need to go to complete the process of normalisation. To get to an answer, we need to know what the risk-free real interest rate consistent with full employment is, as this reflects the underlying balance of supply and demand in credit markets.
A study in 2014 by former Bank of England Governor Mervyn King and David Low was the first that attempts to estimate the ‘global risk-free interest rate’. They use 10-year inflation indexed government bonds across developed nations as a proxy and find that yields have fallen by about 450 basis points since 1987 and are close to 0%. What this means is that developed economies that are neutral on monetary stimulus require nominal yields to rise to around 2-3%. Since many state bonds are not far off, this suggests that the amount of further tightening required from banks is limited.
The drivers of this multi-decade shift are numerous and relate to both the global desire to save (which has gone up) and the demand for credit (which has gone down). This means that global investment as a share of GDP has remained relatively constant over the period despite a large fall in the cost of credit.
The three supply-side factors that have increased the desire to save include: (1) reductions in the dependency ratio; (2) the creation of a savings glut from emerging economies in Asia, and more recently Northern Europe; and (3) rising inequality, as wealthier people save a greater fraction of their income.
On the demand-side, pessimistic expectations for innovation and productivity growth have cooled demand for credit. The falling price of capital also means that businesses need to spend less to meet their production needs.
So if low rates are the new normal, we have to revise our outlook for expected returns for risk assets. If new innovations are not forthcoming and more global capital chases fewer investment opportunities, returns are likely to stay low.
There are risks to policy too. Low rates and volatility will encourage ‘searching for yield’ – that may lead to problems for financial stability down the road.
Additionally, if central banks are committed to low inflation targets, there is much less they can do to stimulate the economy in the event of another recession. Nominal interest rates cannot credibly be held much below 0%, so banks will either need to rely more on unconventional measures such as QE or raise their inflation targets. It also means fiscal policy will be more important in turning around depressed economies.
With real interest rates at close to 0%, the bar for fiscal expansion is effectively lower as debt interest costs become almost a non-issue. The question in the future will increasingly be: does extra spending create at least as much in GDP? And the answer will almost always be yes.
Changes in the global economy in the last thirty years have reshaped the landscape for markets and policy. Today, both markets and policy are in new, unchartered territory. This need not be a bad thing, but the uncertainty puts additional responsibility on the industry to look out for known unknowns and be ready to respond to any unknown unknowns.
Fine Wine, Investing in History
By Anthony Russell, Managing Director at Quantum Vintners
When looking at high-performing wines from an investment perspective, there is a strong leaning to Bordeaux, followed by Burgundy and Champagne, more recently Tuscany and lastly to certain ‘trophy’ wines of the New World. But when and why did these wines become an asset class of their own, with their own performance charts and pricing indices?
To answer this question it is firstly important to review the history of the most prestigious wine-producing regions in France right back to the 12th century. This insight gives us a greater understanding of how they are defined, and the factors which have and will continue to influence their impact on the global wine market.
Bordeaux has a long trading history with England. Its wines were given ‘royal approval’ when Eleanor of Aquitaine married Henry Plantagenet in 1152. The wine producers benefitted from proximity to Bordeaux as a key port and nexus for international trade for many centuries. Tradesmen were attracted to the cosmopolitan city and its wines became well known on a global platform. Over time, the region benefited from significant foreign investment and many of the chateaux founders have English, Irish and Dutch origins. The area became closely associated with success and entrepreneurialism.
During this period, although Bordeaux wines became increasingly popular in England, a preference for burgundies was maintained amongst the French aristocracy. Up until the French Revolution it was Burgundy, known as ‘the wine of kings’ that graced the royal courts at Paris and Versailles. The region was thrown into turmoil with the execution of Louis XVI in 1793 and the withdrawal of the Church from France. When the Church sold off its land to peasants as its members fled, the nobility saw right to do the same.
To understand the development of wine as an asset class it is also worth remembering that investing in wine has always been more to do with the enjoyment of continued consumption of quality than straight financial gain. The landed gentry would buy ten cases from a leading chateau, keep them for ten years, sell five and buy another ten with the profits. In this way, the family would constantly improve their cellar. This practice of ‘laying down’ and selling off continued well into the 1980s.
Thirty years ago, Bordeaux was not the mighty financial force it is today. Its winemakers lacked cash, the infrastructure found in the chateaux was old and, in many cases, broken. The sea change towards wine as an asset class came about primarily because the chateaux required funds for renovations. Viniculture relied heavily on signals from the weather and growers had none of the expertise that now allows them to protect their vineyards and produce very drinkable wine, even when they are regarded as poor vintages. Today the true value for money is to be found in these ‘off vintages’. The top chateaux hardly produce any poor wine these days so investing in the wines from 2002 or 2007 will yield not only some great drinking wines but, hopefully, profit as well.
A further reason for the development of the investable wine market has been the introduction of buying wine ‘en primeur’, the opportunity to buy wines still in barrel. This trend began in the 1970s, providing the chateaux with healthier cash flows and offered the consumer an opportunity to buy at a price that would increase considerably once the wines were bottled and available in the market. This process, whilst still in place, no longer offers investment benefits to the consumer. If anything it has been reversed and wines are often cheaper when available for delivery than when produced.
Why should this be? As the Bordelaise turned a financial corner and found new markets, they started to invest in upgrading their infrastructure and, more recently, in technology. Quality and prices quickly increased, especially for top vintages. There was a general belief that the chateaux could sell as much wine as they liked, due to popularity of consumption. This was, of course, wishful thinking and many ‘negociants’ in Bordeaux still have cellars crammed full of unsold wine.
The golden rule of wine investment is simple; buy a great wine with limited production, ensure that your investment is stored in a reputable bond and watch the price appreciate as others consume it and thus reduce the supply. Buying Bordeaux no longer affords us this luxury. Burgundy, however, is a different story. Production levels are considerably lower and the finest Grand Crus such as Romanée-Conti, Musigny, Richebourg and Clos Vougeot produce as little as 450 cases compared to over 25,000 cases of Chateau Latour each year. For some white wine in Burgundy, such as Montrachet, a single grower’s production can be as little as two barrels – just fifty cases for the global market!
We hope you will be lucky enough to secure something this special for your own cellar.
Buying wine as an investment: Our advice
- Buy from a reputable merchant
- Purchase Burgundy at opening offer prices. Prices vary considerably; opening offers are usually made around December and January for the most recently released vintage
- Buy finest growers Grand Cru and Premier Cru wines from Burgundy
- Domaine Romanée-Conti, Armand Rousseau, Domaine Leflaive, Domaine Dujac
- Clos du Tart, Domaine Ponsot, Domaine des Lambrays
- Store wines in bond
- London City Bond, Octavian, Vinothèque
Outside London, UK property remains strong
It’s an interesting time to observe the UK property market. Uncertainty over the country’s economic and political future comes at the same time as an uptick in global growth, driven by Europe and Asia. With these factors pushing in opposite directions, it shouldn’t be surprising that the current outlook for the property market looks mixed.
UK commercial property
The UK investment volume for H1 2017 was £27.2 billion, which is 1% higher than the same period in 2016. London accounted for 50%. Low levels of investment stock are pushing prices higher. After a spike after the EU referendum, prime rental yields across sectors have fallen back to pre-Brexit levels. The differential between prime and average yields is close to their 180 basis-point 10-year average.
According to the latest RICS survey for Q3, demand for industrial and office use was up over the quarter, but for secondary retail demand was down significantly. Surveyors believe that UK-wide industrials look most likely to secure growth in capital value and rental income over the next 12 months. Non-prime retail looks weak across the UK. Prime office and retail are strong with the exception of London, which 67% of respondents say is overvalued. Despite concerns over London, 3-in-4 surveyors believe the UK market as a whole is fairly-valued, and up to half think the market is still in its upturn phase.
The UK student housing market has also been robust since the Brexit vote. 2016 saw the second highest ever investment volume into purpose built student housing with £4.5bn ploughed into the sector. The combined effect of the weaker pound, the UK’s strong reputation in higher education, and the government’s clarification on the fees and living status of EU applicants has eased concerns. Investors still see student housing as a source of stable and reliable income.
However, there are concerns over data from the construction industry, which fell into recession in Q3 2017. IHS Markit says that the combination of continued uncertainty over Brexit negotiations and fears of higher interest rates has delayed or discouraged new commercial and residential projects.
While sterling has recovered as the economic effects of Brexit have proven to be weaker than expected so far, there are downside risks. Fundamentally, Brexit put a discount on the UK economy of around 10-25% in terms of currency depending on the deal that is eventually struck. This centres new sterling’s long-run value to 1.30$/£ and 1.1 €/£. In the short-term, a weakening of the British economy will push the currency down, but the main worry is the non-trivial risk that Britain leaves the EU without a deal. However, if the government succeeds in maintaining many of the economic benefits of EU membership, the post-vote effects on the currency and the wider economy can be largely reversed.
The Bank of England is likely to raise interest rates in November, with effects already priced into sterling. But if the Bank moves onto a path of further interest rate rises, downward pressure on property prices can be expected if the spread of property yields over government bonds is maintained. This pound will strengthen if interest rates rise without significantly weakening growth.
UK residential property
In the residential market, a clear division can be seen between the performance in London and the rest of the UK. Since 2014, prices for homes valued over £1m in Central London have fallen by 15.2%. The rise in stamp duty land tax by 300 basis points in 2016 to 15% for homes valued above £1.5m is cited as a major reason for the downturn. However, according to Savills, there has been little change in the number of transactions of £1m+ properties in London since the 2014 market peak. Brexit uncertainty is more likely to be a factor as is the growing attraction of other world cities such as Sydney, Toronto and Stockholm. But rental yields point to the key driver. In West London, yields are below 3%, indicating an overvalued market for ownership that cannot be supported by local incomes. Further price falls in 2018 are probable.
The rest of the UK residential property market is in better shape, with year-on-year price growth in October at 2.5% according to Nationwide. Some areas still offer attractive returns to buy-to-let investors. Towns and cities in the South East such as Luton, Colchester and Peterborough offer yields between 4-5%, double-digit capital gains, and strong rental price growth. The North-West region and Wales report strong price and yield growth, with Manchester and Salford doing particularly well. Manchester remains the UK government’s centre for its Northern Powerhouse project, while high living costs in London are pushing people to search for value in the wider commuter belt.
In summary, the UK property market looks healthy but economic and political uncertainty is keeping investors and builders cautious. Downside risks are concentrated in London, where the impacts of Brexit on commercial activity are likely to be greatest and there are concerns over affordability. The fortunes there and across the rest of the UK depend on whether the country stays open for business.
The world is drunk on credit
For the last 6 months, the economic narrative has turned to the idea of ‘global reflation’. Strong economic activity and rising corporate earnings have been a theme for the world economy since late last year. Consumer and investor confidence has risen in both the developed and emerging markets.
But has the recovery relied too much on loose credit? Have we learned anything from the financial crisis? It appears that we haven’t. Excess global liquidity has led to mal-investments in China. It has encouraged managers in the United States to load up on debt and buy-back stock rather than invest in their businesses.
Both the People’s Bank of China and the US Federal Reserve have raised concerns about credit and financial stability. However, the spectre of balance sheet reductions and interest rate rises at central banks in China, the euro area, Japan and the United States threatens to take liquidity out of the global system and bring reflation to a halt.
Credit has been growing at an increasing rate relative to GDP in both the US and China. The incremental benefit of additional credit has been falling. Much of that debt has been raised to fund consumption, finance existing structures (such as real estate), and refinance existing liabilities. This is also the case for the UK, where the savings rate is at an all-time low of 1.7% of GDP. With real earnings stagnant or falling for many, consumer credit is growing at a rate of 10% y/y.
In China, the ruling Communist Party has imposed lending ceilings on its banks and is taking action to restrict credit to underperforming State-Owned Enterprises (SOE) and Local Governments. While these reforms have reduced the number of units of credit to produce a unit of GDP from 5.5 to 3.9, the rate is still extremely high. According to Citigroup, credit provision in China is today half as ‘efficient’ in creating productive output than it was in just 2008. It is about 30% less efficient than it is in the United States.
That’s not to say that US financial markets have been allocating resources prudently. The country has progressively become more credit-reliant since the end of the Bretton Woods system of capital controls. The amount of credit required to drive economic growth has doubled since 1980. The Chicago Fed National Financial Conditions Index shows that a prolonged period of easy credit has existed in the US since 2012, and is similar in scale to the periods representing the dot-com bubble (1995-2001) and the housing bubble (2001-2006).
In the current cycle, according to Absolute Strategy Research, US-held debt is concentrated in companies that have high ratios of capital expenditure to sales, relatively lower levels of cash and high levels of employment. Exposed sectors include Oil & Gas, Industrial Goods and Healthcare. For the largest 500 US companies, net debt has grown faster since 2012 than before the financial crisis. As always, the risks of easy money are not confined to financial stability but extend to the real economy as a whole.
While central banks are rightly concerned with keeping credit growth under control, growing debt-to-GDP ratios have reduced tolerance for higher interest rates. A rate rise from say 1% to 2% may not sound like much, but for a company that loaded on credit at rates of 1%, such a change represents a 100% increase in financing costs. With leverage increasing, there is relatively less real activity to support higher interest expenses.
Central Banks therefore face a dilemma between maintaining financial stability and keeping the real economy strong. A further problem they face is that the performance of the global economy and the strength of demand are related not simply to the supply of credit but the acceleration of credit growth. In other words, if the rate of growth of credit growth becomes too slow, economic output and demand can suffer. The problem for the US is that despite its having easy financial conditions, credit acceleration has actually slowed and this will weigh down on demand and inflation.
The Federal Reserve is therefore caught in a bind between putting a lid on an inefficient credit market for the sake of financial stability and keeping those very lines of credit open to an increasingly addicted economy that is arguably not at full employment. Yet it is hard to believe the Fed is simply looking at what their increasingly flawed Phillips Curve models are predicting about core inflation and reacting accordingly.
That appears to be ostensibly what they are doing. Janet Yellen wants to and has started to unwind the Fed’s monetary stimulus, but she seems to be doing so under the cover that core inflation is likely to accelerate in the coming months. That might happen, but if it doesn’t, the risk going into 2018 is astonishingly that the Fed tightens conditions too prematurely. However, the relationship between interest rates and economic stability in conditions of excess liquidity is not linear, and it may be judged prudent to take some fuel out of the economy now to prevent a bigger problem — perhaps another financial crisis — later on.
Meanwhile, with China responsible for a very large part of the period of global credit acceleration since 2014, some are concerned that credit tightening in China will put strong brakes on global growth through credit markets and the inventory cycle. This certainly was the case in 2010-11 when China last squeezed the credit markets, but there is reason to believe that China is now better equipped to absorb tighter conditions. Private sector investment has replaced spending by SOEs. The labour market is tight, keeping private consumption growth high. And export growth projections are up on the back of the strong recovery in emerging markets.
Yet, similar to the US, there are risks for China in cutting credit growth too fast. Corporate debt has risen from a high 100% of GDP in 2008 to 170% last year. Clamping down too heavily on credit, in the name of making the Chinese economy healthier, could instead make things worse.
It would be too much to say that the global recovery is built on sand. Real activity is up. PMIs look good in the US and the Eurozone. Consumer confidence is growing. And while the inventory cycle has turned in Asia there is good reason to believe the correction will be small. But it is right to say that if the lesson from the Global Financial Crisis wasto reduce the role of credit in fuelling non-productive activities and of leverage in driving the business cycle, that lesson has clearly not been learned.
Why Italy has so much bad debt
The mood in Europe has noticeably shifted this year as a combination of populist defeats at the ballot box and an improving economy has given rise to a feel-good factor. Unemployment, at 9.3% in May, and Q1 growth of 0.6%, suggests that the euro area, after almost seven years of stagnation, is turning the corner.
But recent developments regarding Italy’s banking system ought to give pause for thought.
The ECB is concerned about bad debt in the banking system and its concentration in Italy. And they should be. While lenders across the euro area directly supervised by the ECB are exposed to sour loans worth €915bn, or about 4 per cent of total exposure, Italian banks alone have €326bn of exposure to non-performing credit.
To attempt to address this problem the ECB recently called for banks to cover the unsecured portion of all bad debt within two years, and for all of it within seven years. This will raise the cost of holding debt for banks, as only around half of Eurozone bad debt is covered by borrowers’ collateral. The likelihood of fire-sales of NPLs risks reducing banks’ capital ratios and thus lending. The Bank of Italy and former PM Matteo Renzi have complained that these measures threaten Italy’s fledgling recovery.
Italy’s fragmented banking system
With over 400 national and regional players, Italy’s banking sector is highly fragmented and localised. This has created a source of systemic risk in Italian banking as many of these lenders have opaque and politically-influenced lending practices, with prudence often taking a back seat.
According to ECB and IMF research, even as Italy holds a third of the eurozone’s NPLs, a much higher rate of bad debt is held in banks in the south of the country than in the north. It is alarming that the problems that have surfaced to-date – in banks such as Popolare di Vicenza, Veneto Banca and Banca Monte dei Paschi di Siena – are situated in Italy’s industrial north than in the old Bourbon states of the south, where credit allocation is more suspect. The same IMF study found that three-quarters of Italy’s NPLs are related to the corporate sector, with the construction, services and ‘less technologically intensive sectors’ most badly affected. These are typically industries that are more localised and more ‘southern’.
To understand why Italy is in such a pickle today, it is worth looking at some recent history.
After a social pact in 1993, promising to coordinate the country’s industrial, labour and financial systems, Italy had an opportunity to become a German-style economy. But these reforms were watered down and basically abandoned after Silvio Berlusconi came to power in 1994. Instead, Italy remains stuck as a state that relies heavily on the government to keep the social peace by compensating losers and strong political actors. Banks are merely one of the tools at its disposal.
Historically, Italy has had a financial system that was largely based on patient capital especially at the SME level. The country’s corporate structure is marked by ‘pyramidal ownership’ that allows families or other entities to control large parts of Italian industry with relatively small ownership stakes. Families develop long-term relationships with banks, which in theory should lead to system that is relatively stable and low-risk. However, the state has always had a great degree of influence over the allocation of capital across the financial system, and that remains despite waves of bank privatisations since 1979.
Today, politicians exert influence in Italy’s financial system through the system of ‘foundations,’ opaque, non-profit bodies that were set up in the 1990s to ensure lending remained in the ‘public interest’. Foundations own just 23% of Italian banking assets but control the boards of the country’s largest banks. In Unicredit, foundations own just 9% of stock but control 84% of seats on the Board of Directors. Almost half of foundations are elected by local authorities, and 60% of the seats on the board of Foundazione MPS and 55% at the Fondazione Cariplo (Intesa) are held by local politicians.
Italy’s banking crisis in context
But there’s a bigger problem here, and it relates to the political economy of the Eurozone. In the euro area there are two groups of economies, export-led economies in the North (such as Germany, Belgium, the Netherlands and Austria) and demand-and-credit-led economies in the South (such as Greece, Italy, Spain and Portugal).
States in the north steadily gained competitiveness vis-à-vis the South in the early 2000s by holding wages down and cutting unit labour costs through improvements in products and processes that raised productivity. Coupled with low domestic demand, particularly in Germany, this created a situation of excess savings in the euro-North (Germany) that were channelled into the euro-South (Italy) and established the trade imbalances that underpinned the first euro crisis.
Because the EU’s institutions place constraints on national economic and fiscal policy, and because member states do not have their own currency, southern states, including Italy, used their leverage on banks as a partial substitute for tools it would typically use to keep the social peace. These states were helped along by low interest rates and risk premia that were more relevant to Germany than to countries like Italy.
Credit growth, supported by capital inflows and implicit bailout guarantees, replaced fiscal management as an engine powering domestic demand growth in the euro-South. It also turbo-charged imports of the high value-added goods from the North that countries in the South did not produce itself, leading to large trade deficits. German credit was squandered on businesses and projects that were low-value and often non-tradeable, merely serving to raise inflation and sustain the competitive trade imbalances that drove the credit flows in the first place. This is the reason why Italy today has so much bad debt. It’s a combination of the design of the euro area and problems within Italy’s political economy.
Deeper levels of scrutiny that are typical within systems with more capital depth were absent, making southern European states more exposed to financial risk than other countries that had high trade deficits, such as the UK and USA. It was these self-fulfilling fears of insolvency that originated mainly in the poor state of private credit markets, and the tight link between the health of national banking systems and public sector liabilities, that led to the sovereign debt crises of the 2010s.
Necessary reform
It now appears that officials in the ECB realise that the Italian banking system needs to be reformed, not just to isolate the mountain of bad debt and to prevent another financial crisis, but also for long-term reasons. There needs to be more accountability and transparency too.
Part of that involves bank consolidation. Consolidation has worked for Spain, which has reduced the number of its savings banks (cajas) from seventy to 12 since the financial crisis, with the Spanish economy growing strongly on the back of investment and exports. Consolidation with regulation that ensures that no bank becomes too big to fail is needed to improve the Italian and wider European banking system.
With the euro-area enjoying a sustained economic recovery, the last thing its leaders want is fears of another banking or political crisis to weigh it down. The price to pay in the short-term might be a hit to the Italian economy, but this perhaps is a price worth paying, both for Italy and the wider euro area.
Has the UK economy really recovered?
In the UK, the crisis in the cost of living is back, as inflation, coming in at 2.9% in the year to August, has again risen above wage growth. The Bank of England says a major factor is the fall in the value of the pound since the EU referendum result, which has increased the costs of imports – in particular energy. Wage growth, up 2.1% in the year, hasn’t kept up. Adjusted for inflation, real incomes fell by 0.4% in the three months to July 2017.
Meanwhile, unemployment at 4.3% is now at a 42-year low, continuing to confound observers about the strength of the UK recovery as wage growth remains weak.
It may not feel like it but it is now over ten years since the financial crisis began, and we are nine years into a bull-run in equity markets in most major markets. Formally, the economy is said to have recovered. Unemployment is below its long-term trend of around 5%. Growth has been positive for many years, despite severe headwinds from years of fiscal consolidation. Inflation is rising.
Yet there is one highly abnormal feature of the British economy that could explain the weak growth in real wages. For the best part of a decade, the productivity gains that have driven rising living standards in the UK since the start of the industrial revolution have stalled, at least according to official data. Much of the increase in GDP since the crisis has come from ‘labour input’ – more people in work (often supported by high levels of net migration), people working longer hours, and more people returning to the workforce.
Low growth in labour productivity has meant that ordinary people in the UK have felt next to no benefit from the recovery of the economy in the form of rising wages. The return of high inflation threatens to put any gains they did see into reverse.
But is this the full story? Our research suggests that the productivity slowdown seen in the UK has been seen to varying degrees in all other G7 countries, but the performance of the UK should be an additional cause for concern. The UK has done particularly poorly due to unique frictions within its economy that have emerged post-crisis.
Figure 1 shows how the evolution of labour productivity, measured in terms of output per head, was faster in the UK between 1970 and 2008 than in other G7 countries. Starting from a lower level in 1970, productivity in the UK grew on average by 2.3% per year and by 2.0% in the other countries (weighted by share of total GDP), which included technological leaders such as the United States and Germany.
However in 2008, productivity decoupled from its trend in all advanced economies, with the biggest deviations in the UK. One would expect this at the beginning of any recession as weak demand creates ‘spare capacity’ in labour and capital. But this phenomenon should not last. In all other recessions since 1970, productivity soon returned to trend.
The impact can be seen in Figures 2 and 3, where we see the deviation of output per hour from the level implied by trend for the UK compared to the world’s technological leader, the United States, and then compared to all other G7 countries.
The UK and other G7 countries continue to deviate from their trend rates but to vastly different degrees. The US has also experienced low productivity growth in the last 5 years causing it so far only to revert back to its long-run trend level after a decade of rapid growth. But if the US continues to underperform on official measures, as seems likely, it too will slip below its pre-2008 trend in the coming years. The UK, however, appears to have done especially badly. Productivity (and therefore real wages) in the UK is 20% below where it should be based on recent trends, compared to just 10% below-trend for rest of the G7. More on the UK’s problems later.
The productivity slowdown across the G7 suggests one or more of four things has happened. Either demand remains too low in all industrial economies; the pre-crisis trend rate has fallen across the G7 due to structural changes in the economy; the pressure to deleverage in the wake of the crisis has reduced the willingness for firms to invest in products and processes that increase productivity; or productivity gains have not been picked up by the statisticians.
The demand explanation cannot account for a decade-long trend, and apart from a short policy-induced scare in 2015-16 in the Eurozone, deflation has not been a major issue in most of G7. It is possible, however, that delivering more robust and sensibly designed fiscal action sooner would have sped up the recovery ameliorated some of the productivity problems we now face.
While we are sceptical that the long-term trend that has driven growth in the United States and its trading partners for up to 150 years should be revised fully downwards to meet the most recent trends, we think a moderate deterioration in trend growth is a possibility. Mainly this is due to a decline in secular returns from a range of general purpose technologies – such as electric power and mass production – and the growth in the share of the low-productivity services sector in all G7 economies. The financial crisis may have simply exposed these underlying changes.
It is also plausible that as a result of the financial crisis and the experience of deleveraging, firms have increased their risk aversion and are reluctant to invest in the emerging general purpose technologies in nanotechnology and biotechnology, which promise a step change in industrial activity. This would also suggest a reduction in the trend-rate of growth, at least in the short term, across the whole of the G7, meaning lower growth can be consistent with full employment.
The fourth reason – that productivity gains have been hidden – we believe explains a significant proportion of the shortfall in all G7 countries including the UK. The emergence and growth of the Information Technology sector have hidden real productivity gains that have been realised since 2008.
A smartphone today, for example, has taken the place of a number of other devices such as cameras, GPS, audio players and games machines; and to a more limited extent they have substituted for personal computers altogether. Despite this, the cost of smartphones has fallen. Product consolidation in consumable electronics and IT sectors means that the formal measure of GDP understates the true level of output, adjusted for quality, and goes some way in explaining why productivity is low relative to the level of employment. Further, GDP statistics do not account for non-monetary transactions, such as content produced on social media or the services provided by free app technologies that underpin the ‘sharing economy’.
But for the UK economy, further underlying aspects can be highlighted, as pointed out in 2014 in a paper from Bank of England’s Monetary Analysis Directorate. They suggest that low interest rates have increased forbearance from banks on the debts of firms that in normal conditions would have been allowed to fail. Moreover, credit frictions have prevented funds from being matched with new profitable opportunities, and a sustained fall in real wages relative to the price of capital has encouraged firms to delay investment by expanding employment.
So while a global phenomenon of depressed productivity growth exists, the problem seems particularly acute for the UK. Our research suggests that the UK has suffered a decade of lost productivity growth but that it is closer to full capacity than implied by its pre-crisis trend. This means that the country may face a period of stagflation – weak growth and high inflation – that will create a dilemma for a Bank of England that is committed to keeping inflation at 2%. As inflation rises, real interest rates fall and sterling continues to weaken, the UK economy could begin to overheat. At which point, the Bank will be encouraged to raise base rates. But this could reverse efforts to raise productivity and if markets have little tolerance for higher interest rates could create more adverse macro effects.
This is the near-term outlook, However if, as the technologists suggest, we really are on the cusp of a new industrial revolution, which promises to offer quantum leaps in productivity and living standards, the long-run prognosis for the UK and indeed the rest of the G7 need not be so bleak.
Our View on Active and Passive Investing
The growth of passive investment products such as index tracking funds over the past few years has been significant as investors are attracted by low fees and the premise that the majority of active managers will not outperform the market over time. Passive investing, or indexing, involves buying a basket of assets that have been included in an index, such as the FTSE 100 Index or the S&P500, or sectors thereof without having to undertake the research and due diligence associated with an active investment decision as performance will mirror the overall movement of the market.
However, some investors argue that the increase in passively allocated money risks distorting the price discovery process. Active investors look to invest in companies whose shares and bonds look cheap and sell those that look expensive, thereby holding management to account by basing decisions on fundamental factors such as earnings growth; competitive prospects and management performance. Price agnostic or passive investors reduce the proportion of share price movements that are based on fundamentals, creating serious market anomalies by being obliged to buy already over weighted and overpriced assets.
This situation is more serious in the less liquid markets of corporate and high yield bonds where passive funds offer total liquidity in an index such as the Citi World Government Bond Index where the level of liquidity of the underlying index components may not compare. Furthermore, the more indebted a company, the more bonds it is likely to have issued, the greater its weight in the index meaning that a passive bond fund will effectively hold a high weighting of bonds in the less credit worthy members of the market place.
The use of passive products in less diverse markets could further contribute to overvaluation and provide a destabilising effect. For example buying sector specific exchange traded funds (ETF) such as the technology sector where market capitalisation may be skewed to a small number of very large companies that would risk breaking some basic investment rules regarding insufficient diversification and exposure to large individual holdings. The performance of the technology sector since Trump’s presidential win has seen Facebook, Apple, Google, Microsoft, and Amazon become over 40% of the Nasdaq 100 Index, which would be in breach of European fund rules if an active manager was to follow the same asset allocation.
Modern portfolio theory would argue that the primary driver of portfolio returns is asset allocation, which is the process of combining various asset groups with different risk and return characteristics (e.g. equities, bonds, cash, private equity, hedge funds, real estate) into one portfolio that will produce optimal, risk adjusted returns. An active investor believes he can outperform a set benchmark by using his skills in market timing, stock selection or style tilt. Smart-beta strategies are semi-active products that reweight on a regular basis in order to maintain an allocation that historical back testing would suggest has been the optimal mix over time. This blurs the boundaries between active and passive by offering the investor one asset allocation remedy based on past performance that any standard market disclaimer would state may not guarantee future success.
There has been a long debate over the relative merits of active and passive approaches to investment when both approaches probably deserve a place in a diversified portfolio. Recent opinion concludes that the ability of active management to generate alpha is probably cyclical; underperforming when returns are overly concentrated or highly correlated such as times when interest rates are low, and, outperforming as economic growth improves, interest rates normalise and market inefficiencies increase. Active managers also have the benefit of making the decision not to be fully invested by holding cash in difficult times which should provide significant downside protection.
How Appropriate is the Taylor Rule?
The Taylor Rule, established by economist John Taylor in 1992, tries to target a level for short term interest rates that will stabilise the economy whilst maintaining long term growth based on three factors:
Actual inflation levels
Full employment vs. actual level of employment
Short term interest rates consistent with full employment
This means the rule will recommend raising rates when inflation is high or employment exceeds the perceived level of full employment and vice versa. Like all economic models, it is only as good as the data input, in this case assumptions about the long run neutral rate and the cyclical position of inflation. Historically, however, the Taylor rule has proved a useful guide to the appropriateness of monetary policy.
The change in central bank rhetoric would indicate that we have reached an inflection point where historically accommodative monetary policy will start to be reversed through the tapering of quantitative easing measures then the raising of interest rates.
Baseline Taylor Rule Estimate for United States
Source: Bloomberg
At the peak of the financial crisis in mid-2009 the Taylor rule suggested that US interest rates should target a rate of -2%, but the Federal Reserve unsure of the effects of negative interest rates instead embarked upon a quantitative easing project designed to reduce the overall cost of credit by employing its own balance sheet. By 2013 the rule was advocating rates be raised to approx. +1% encouraging Chairman Bernanke to embark upon the first tapering of QE that caused the summer tantrum in the US Treasury market.
Today the Taylor rule suggests that rates should be nearer 3.75% in the US which is probably the largest disconnect between the theoretical normalisation of rates and actual interest rate policy sparking debate about where the peak in this hiking cycle will ultimately prove to be. For many the current neutral rate is believed to be around 2%, much lower than the historical average of nearer 4%, but probably explains the Fed’s new commitment to tighter policy despite the absence of wage inflation in the system. In any event it seems clear that fundamental models such as the Taylor Rule are pointing towards higher rates and the phasing out of QE.
The Fed is expected to announce balance sheet reductions in September leading to another hike in rates in December; The ECB to move to a reduction in QE during Q4 17, the Bank of Japan’s balance sheet growth is reducing; and the BOE surprised many with its more hawkish rhetoric of late leading the Gilt market to adjust its rate hike expectations in the UK. The causes of the higher levels of inflation in the UK are creating a greater divergence between actual and theoretical rates which may explain the difference of opinion in the future path of interest rates.
From the bond markets perspective the adjustment to higher rates will generate capital losses as yields move higher and if handled badly by policy makers negative sentiment could spread to other areas of the economy. Expect central banks to offer high levels of forward guidance and move forward very cautiously as they remove support from the financial markets.
A Brewing Storm
Just as the dust started to settle with political stability somewhat mitigated and investors focus now on corporate earnings as a means of justifying high global valuations, Italy comes to the forefront. European markets have performed strongly and valuations are becoming stretched so that even the smallest shock would likely see equity markets weaken the question is to what extent? Italy, known for its political instability, high debt and resulting drag on the European Union is in desperate need of effective leadership and structural change. The political parties of Italy recently announced that they are in the process of coming to an agreement on new electoral law that, if successful, will almost certainly lead to early elections this September. The announcement on May 16th saw markets deteriorate slightly, primarily in Italy where the FTSE MIB fell 2.31% followed by two falls of 2% on May 26th and 29th as the news unfolded. The most significant decline was in Italian Mid Caps which fell 2.51% led by financials. However, the relatively sober response suggests investors believe there is a low chance of a populist party being elected and subsequently an Italexit.
The Italian and German bonds spreads widened as the yield on an Italian 10yr government bond hit 2.18% (a 6.77% increase). The change in spread represents an increase of 188 basis points. Citigroup predicts spreads to widen further to as much as 300 basis points, levels that haven’t been seen since 2013.
German Bund / Italian BTP 10 year Yield Spread
Source: Bloomberg
With the recent win of Emmanuel Macron as French President and the likely triumph of Chancellor Angela Merkel the Euro currency has been the stronger major currency, a further reflection perhaps that most investors currently place a very low probability of a populist triumph.
Should Italy’s political parties come to accept an electoral reform it is likely to take a shape similar to that of the German model; proportional representation with a 5% threshold. Considering this, and looking closely at the most recent election polls, only four of the political parties make the 5% threshold. The PD and 5SM stand at 30% each, Forza Italia and Northern League in the low teens and no party is on course to win a majority so a coalition is almost certain. Currently, consensus seems to suggest a coalition between PD and Forza Italia (both pro-EU parties) however 5SM and Northern League should not be ignored. Both are anti EU and would call a referendum. Should this coalition become likely, we would expect to see a big sell off in markets.
In conclusion, there are a few immediate obstacles to observe. The state of the Italian economy is the first and will most definitely play a part in influencing the outcome of the election. Support for the 5SM seems to rally whenever news of Italy’s economic performance turns for the worst. Initial economic reports this year have been promising with strong results coming from boosted inventories and consumer spending. If this continues, Italians may rally behind the PD. Secondly, poll predictions will likely influence markets and be a good indicator as to the possible outcome of the elections. Looking back at the Italian referendum, polls were fairly accurate in forecasting the vote and so investors will expect this to follow through in the elections. Finally, keeping a close eye on the interaction amongst parties. If the 5SM and Northern League form a coalition, it is very likely they could win the election. The result will see devastating effects to the markets. We remain cautious in the short term upgrading risk to ‘medium’.