Surprise! Another referendum.

By Eoin Fahy, Tuesday, 28th February 2012 | 0 comments

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.


The government surprised the country, and the financial markets, by announcing this afternoon that a referendum will, after all, be held to approve (or not) the Fiscal Compact. This was not at all expected as the treaty text had been drawn up with the explicit intention of avoiding the need for a referendum, and as the government presumably wanted the referendum about as much as a turkey looks forward to Christmas! The euro weakened after the announcement, and Irish bond yields rose, though in both cases the moves were not especially large.

The timetable is not fully clear, but this will not be a quick process. As a first step, the government will have to publish the legislation to provide for the holding of the referendum. Presumably that will take a week or two, at the least. Then that bill will have to be approved by the Dail and Seanad and signed by the President. While that process can often take several weeks, it can be done quite quickly, say within a week or two, if it is seen as a very urgent priority.

After the legislation is passed, the date for the referendum will be set, which is usually at least a month after that. So if we assume that the Bill passes sometime in late March, a guesstimate for the date of the referendum would be sometime in May.

The political merits or otherwise of the Fiscal Compact are not a matter for this blog, but from an economic/investment point of view it is worth taking a look at the consequences of a No vote. The key "black and white" issue is that Ireland will not be able to borrow from the ESM (the EU bailout fund that takes over from the current bailout mechanism, the EFSF, next year) if it does not sign up to the Compact. So the current bailout funds are not at (direct) risk from a No vote, but if Ireland cannot return to the markets within the next year or so, and fund itself, it will be in very severe difficulties as it will not be able to get a second bailout.

Of course there are "greyer" consequences as well. While Ireland can continue to draw down funds from the current bailout, it will certainly lose goodwill from other EU countries [except the UK of course, which has opted out of the compact], and could hardly be expected, for example, to get concessions re the €30bn+ promissory note on which there is so much focus by government at the moment. A No vote might also make some inward investment companies, and bond investors, think twice about the wisdom of investing in a country that (again!) votes against an EU treaty, if they think that that might mean that Ireland will leave either the eurozone or the EU.

On the other hand, of course, the irony is that the Compact is supposed to give taxpayers in richer countries such as Germany some comfort that their money will not be used to support countries which cannot, or will not, get their fiscal affairs in order. But most economists agree that even if it had been in place during the boom years in Ireland, it is unlikely to have made much, if any, difference, and Ireland would not have broken any Compact rules until after the bubble burst, by which time of course the damage had already been done. Many economists also argue that the fiscal rules in the Compact are not well designed and would be quite difficult to enforce in practice.

No doubt we will all be discussing these and related issues in much greater detail in the weeks ahead, but for now, perhaps the biggest impact will be in the uncertainty that will not be resolved for, perhaps, two to three months while we await the vote.

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Recent blog posts

Investment Outlook: Hit me if you can!

Apr-7-2014
By Noel O'Halloran  | 0 comments

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.

Despite these ‘hits’, global equity market performance proved to be very resilient with the world equity index rising by 1% in local currency.  Europe led the way, with the eurozone index rising 2.8%, slightly ahead of North America, which rose 2%.  Japan was the laggard, showing a decline of 7.5%, while Emerging Markets were down very slightly (all returns in local currency).  In contrast, bond markets (in Europe in particular) appeared to benefit from falling inflation and improved sentiment towards peripheral countries,  and delivered strong gains as the European over 5-year bond index rose by almost 6%.  Commodities were very strong, rising by about 7%, regaining some of their losses in previous quarters.

Hits perceived as transient

It’s very clear, therefore, that markets regarded these ‘hits’ as transient and focussed instead on improved long-term fundamentals.  That is not particularly surprising given that I believe that the current global economic recovery has at least another three years of growth before we concern ourselves about the next economic downturn. The continued slow but steady global economic recovery will prove resilient and continue to demonstrate recovery. I reiterate my strongly held conviction that real assets such as equities and other alternative asset classes are attractive for as long as  global central banks are fighting deflation and downside risks to economic growth. While in the short term such actions also help bond yields, in time recovery will prove a big negative for bonds.

In January, I expected 2014 to be another positive year, with a likely outcome of high single/low double digit returns from global equity markets. This would be consistent with expected global earnings growth for 2014. Equity markets are no longer cheap and are generally now trading at long term average valuations. Therefore, my central expectation was and remains  that returns will be consistent with earnings growth from here out rather than further expanding valuation multiples – though there remains some possibility that abundant liquidity could push valuations up still further. 

What we are watching

As we enter the second quarter there are a number of key fundamentals that we are watching:

  • A key factor will be the upcoming company earnings reporting season. While many US companies (cyclical ones in particular) will no doubt have been hit by adverse weather during the first quarter, their outlook, commentary and guidance for the remainder of 2014 will be very important to markets.
  • At a macro level it is crucial that the US economy does rebound from the weather affected first quarter. I certainly expect it to, having spent some time looking at this issue while in the US recently on a research trip.
  • A missing ingredient from this recovery has been any material sign of growth in corporate capital expenditure. We are at a stage in the economic cycle where many economists expect to see increased signs of such a pickup. This new dynamic would be a positive not just for economic growth but in particular for corporate earnings.
  • Although we have no official numbers yet for the first quarter economic growth in China, it does appear to have been particularly slow. I maintain the view that the economy will not have a hard landing and Premier Li has said several times in the last few weeks that he had means and ways to protect the economy from deterioration if necessary. A natural rebound in growth, or one helped by further stimulus measures by the government would be positive catalysts and further welcomed by markets.
  • For over 12 months now equity market performance has been polarised between strong developed market performance and struggling Emerging Market (EM) performance while EM battled with a number of headwinds. Over the remainder of 2014 I expect this trend to reverse and EM to gain positive traction again. This will have to be driven by a pick-up in both earnings and economic growth.
  • While a rising tide hasn’t to date seen any significant differentiation between US, Europe and Japan, I believe that there is a real chance that markets will challenge this more and focus on whether the latter two are truly synchronised with the US economic recovery or whether they are in fact struggling and deflationary forces are materially different for Europe and Japan than in the US. To date, markets have given them the strong benefit of the doubt but I note that the ECB for example has spent a lot of its recent press conferences discussing what tools they have at their disposal to fight deflation, if necessary.  If the economy is recovering, as the markets believe, why is inflation so exceptionally low?

Emerging Markets

It is worth expanding further on my views on Emerging Markets, as markets are very focussed on that topic.  As I stated above, I believe they will begin to converge again with Developed markets, and for those looking for a ray of hope, Emerging Markets had a significant outperformance over recent weeks. At a fundamental level while challenges remain (growth and politics) across various emerging markets, I believe we are well past the worst and that the key catalysts of economic growth and earnings growth  will help over coming quarters.

It’s important to note that investor sentiment and positioning is very poor towards EM. This is not at all unusual as historically investors either hate or love emerging markets with seemingly no in-between state! Any investor with a grain of contrarian instinct would be looking to buy EM and particularly as valuations are well below historic averages. This is also against a background where some argue that many investors are increasingly ‘in love’ with developed markets such as the US. At a fundamental level, although challenges remain, EM economies are in a much healthier state than they were ahead of the 1997 Asian crisis and I do have confidence that the Chinese will manage the rebalancing of their economy without a hard landing.

Investment markets remain as dynamic and challenging as ever. In this quick blog I have summarised some of the major drivers we will continue to focus on during the second quarter. Within markets and for your portfolios we are also managing both sector and style volatility. By style I mean whether for example value, growth, momentum or yield are performing best and we have noted more volatility in styles over recent months. Consistent with a slow but steady recovery in global economic growth we continue to believe that stock picking should remain concentrated on companies with strong balance sheets, positive earnings guidance and a strong attention to cash flow and dividend payments. The bottom line remains that I expect 2014 to be a solid if not unspectacular year of returns for investors despite the headline challenges.

Noel O’Halloran, Chief Investment Officer

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.

St.Patricks 5K winner Thumbnail0

Second place went to Colm Rooney from Clonliffe Harriers AC who finished in 00:14:23. He was followed in third place by Kevin Maunsell of Clonmel AC in a time of 00:14:43.

The women’s race was contested by two of the biggest names in Irish athletics with current star Fionnula Britton holding out against former London marathon winner Catherina McKiernan who made a rare competitive appearance for this event. Fionnula Britton completed the course in a time of 00:15:33 and Catherina McKiernan completed the course with a time of 00:15:58.

Fionnuala Britton is currently one of Ireland’s top athletes and was the gold medallist at the 2011 and 2012 European 2012 European Cross Country Championships and was the first woman to successfully defend this title. She has represented Ireland in the steeplechase at the 2008 Beijing Olympics, the 2009 World Championships in Athletics, and twice at the European Athletics Championships.

St.Patricks 5K women s winner Thumbnail0

Veteran athlete Catherina McKiernan is a double Olympian and  has won four silver medals at the World Cross Country Championship and gold at the European Cross Country Championship. She has had notable success at marathon having won at Berlin, Amsterdam and London and holds the Irish national record at the marathon distance which was set in 1998.

Third place went to Lifford AC athlete Ann-Marie McGlynn in 00:16:01. 

Organised by Metropolitan Harriers & St. Brigid’s Athletic Club, the race was a highlight of the annual St. Patrick’s Festival programme and a major element in attracting tourists and visitors to Dublin City. The record 1,700 entries were made up from dedicated athletes, families, tourists and fun runners alike.

St.Patricks 5K race start Thumbnail0
Praising the efforts of all who took part, race director Eamonn Coghlan thanked Dublin City Council and An Garda Síochána for the support which they had given to the event.
 
Sponsorship was provided by Kleinwort Benson Investors, specialist provider of niche investment strategies for pension funds, charities and corporate bodies, who have supported the event for a number of years. 

As an added attraction this year and to coincide with their forthcoming Muppets Most Wanted movie, Disney held a competition for the ‘best inspired Muppet costume’ in the race which was won by 11 year old MSB AC athlete Sarah O’Gorman from Castleknock whose prize is a private screening with 100 of her friends!

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’.KBI078 white Thumbnail0

We are now over five years on from the worst of the global financial crisis and the global economy is moving from the post-bubble phase to a phase of ‘self-sustaining normal growth’. I expect all of the large developed economies to grow more strongly in 2014 than they did in 2013.  The improvement is likely to be strongest in Europe, with the economy returning to positive growth this year.  The picture is slightly different in Emerging Market economies, where growth has been reasonably strong for some years, but has faded somewhat in recent months.

Equity markets have of course correctly anticipated this improvement, with strong returns in 2013.  The likelihood for 2014 is that equity markets will match earnings growth (rather than exceed it), producing positive but more modest returns than 2013.  In contrast, the outlook for bond markets is negative, as central banks, and particularly the US Federal Reserve, move away from their policy of massive liquidity creation. Alternative asset classes such as commodities had a less positive 2013 but I suspect they will be more competitive in a diversified portfolio this year. I am all too aware that these optimistic views are much more consensus today than they were 12 months ago and the degree of bullishness amongst investors is increasingly high, which has historically been an uncomfortable place to be!

I have no doubt that there will be challenges to markets as the year unfolds and in this blog I will focus on the key risks – both upside and downside! – to markets this year.

The following are scenarios or risks we consider in descending order of likelihood for 2014:

 Risk 1: Economic growth turns out to be much stronger than expected:

Such an outcome would certainly be a major negative for bond markets and would exert more of a two-way pull on equity markets which could lead to a flattish out-turn for equities. We witnessed such an environment in 1994 where stronger than expected economic and earnings growth were offset by sharply rising interest rates. In this scenario much will be written about central banks being ‘behind the curve’ as bond markets create headlines of an ‘inflation scare’. 

Risk 2: Equity market valuations reach expensive levels

In this scenario, ‘easy money’ from global central banks continues to be funnelled into equity markets and other risk assets rather than into the real economy (which itself doesn’t accelerate as expected but rather continues to muddle along).  Just as in 2013, equities deliver acceptable earnings and dividend growth but are turbo-charged by a further expansion of P/E multiples into expensive territory leading to a stellar 20-30% equity year.

Risk 3: Emerging Markets materially disappoint

In this scenario the struggle of 2013 would turn into a meaningful ‘actual’ issue, such as materially slower than expected growth in the Chinese economy or an unexpectedly negative market reaction to ‘tapering’ (incidentally, I believe that to have been last year’s story). While the coincidence of a material slowdown in emerging economies occurring at the same time as developed economies are accelerating would be very rare, it would be very messy for equities and positive for developed market bonds.

Risk 4: Europe IS the new Japan

Recent nascent optimism about a genuine recovery in European economy quickly fades as the green shoots of growth wither and die. ‘Japanification’ of Europe becomes the jargon phrase of the year (replacing ‘tapering’!).  The ECB again becomes the focus of attention and the euro weakens materially. Peripheral Eurozone bond markets also become vulnerable as core defensive bond markets come back into favour.

Risk 5: A year of 2 or maybe 4 halves!

Some combination of some or all of the above could occur leading us to expect a very dynamic roller-coaster type year. We have been there before!

Summary: 2014 similar to 2013

I expect that 2014 will most likely be a similar but less spectacular year to 2013 echoing many similar trends with the strong exception that I believe Emerging Markets will perform much better in 2014. Valuations (in Developed equity markets) are no longer cheap but I remain confident that earnings and in particular dividend growth will be even more important in this year than they were in 2013.    Risks abound of course – both upside and downside – as I’ve outlined above but the bottom line is that I expect that investors will reap solid – if unspectacular – gains from equity markets this year.

 

Noel O'Halloran, Chief Investment Officer

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?

Let’s start by looking at the national debt. The bad news is that of course it is at a very high level, about 124% of GDP. That’s about €45,000 of debt for every man, woman and child in the country. By way of international comparison, as the chart below shows, it’s the fourth highest in the EU, after Greece (170%), Portugal (132%) and Italy (134%). debt to gdp

The good news (though it that much to shout about) is that this year should mark the peak, and on reasonable economic forecasts the debt should be down to about 114% by the end of 2016, as this chart shows (using Department of Finance projections).

debt to gdp over time

Next, let’s look at the deficit, the gap between what the government takes in and what it spends. This year that deficit will be about 7% of GDP, or €11.5bn. That compares to a peak – excluding the money needed for bank rescues – of 11.4% in 2009. Ultimately the budget needs to balance, of course, but first the deficit needs to at least fall to 3% of GDP as that is the highest level accepted by the EU under its fiscal rules.

defict as pct gdp

So the bad news is that – at first glance - we are only about half way from the worst point (11.4%) to where we need to be (3% at max). But that perhaps understates the extent of progress, as the economy has now begun to grow. And it is economic growth, above anything, that will get the deficit down. We expect that that growth, combined with some relatively modest spending cuts and tax increases in the 2015 Budget, will drive the deficit down to below 5% next year, and to below 3% in 2015.  In fact the graphic below (from the NTMA) shows that the vast bulk of budgetary consolidation (or austerity measures, if you prefer) is already complete.  To be exact, of the 20% of GDP of budget measures that are due to be done between 2008 and 2015, 18.9% has already been done.austerity so far

So a stock-take of Ireland’s fiscal situation shows a mixed picture. The deficit has already come down substantially and the pace of decline will accelerate from here. That is vitally important as once the deficit is eliminated, or reduced to an acceptably low level, austerity measures will no longer be required.

But on the other hand the outstanding stock of national debt that has built up as a result of the huge deficits of the last few years, and the need to rescue the banks, remains very high and will only begin to decline slowly from next year. Ireland will need to continue to run very cautious fiscal policies for as long as that stock of debt – and the interest burden on it –remains at high levels.Austerity measures may be coming to an end - but Ireland is a very long way from being in a position to begin to substantially increase public spending or cut taxes.

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.

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!

Most public and media focus on any budget is on a few controversial measures that get the headlines, but which are often very minor in terms of the overall budgetary arithmetic, or indeed in terms of what needs to be done to get the economy moving, reduce unemployment and exit the bailout arrangements. At this early stage it seems quite likely that the main debate about the Budget in the days ahead will be about very specific issues such as the abolition of the bereavement grant or the reduction in the number of elderly medical card holders.  These are, it goes without saying, very important issues to those directly affected, and indeed important social issues, but it is sometimes unfortunate that the really important budgetary decisions - in broad economic terms - are almost overlooked in the entirely understandable reaction to particularly controversial measures which are minor in overall budgetary terms.

And this Budget does indeed merit serious consideration at a macroeconomic level:

  •  It is the first Budget where the Irish government decided to essentially overrule the troika and bring in a much smaller package of austerity measures than previously agreed. 
  • It marks the return to what economists call a "primary surplus", i.e. the budget will be in surplus when interest on the national debt is excluded. 
  • It is the first Budget in a long time that is taking place at a time when there are genuine indications that the economy is picking up somewhat, and the approaching light at the end of the tunnel may not, in fact, be the light of an oncoming train!

If Budget 2014 was Budget 2012?

Turning to the first of those broader issues above, it is interesting to think about what might have happened if, say two years ago, the Irish government had overruled the troika and reduced the amount of austerity in the budget by 20%, as it has done this year.  It seems very likely that Irish bond yields would have risen substantially, while various European policymakers would have made grave comments about the lack of commitment from Ireland to restore its finances to good order. The troika would, no doubt, have at least threatened to delay or withhold further funding, and it would have been near-impossible for Ireland to raise any money in the bond markets.

But this is late 2013, not late 2011, and the balance of power has shifted.  In reality, the government no longer needs troika funding - it has access to the financial markets instead, and also has a very large reserve of cash on hand.  And the international environment has changed as well, as the eurozone fiscal crisis seems to be steadily fading. So the government felt strong enough to essentially tell the troika that it didn't agree with the scale of austerity measures previously agreed.  Nominally, the reduced austerity measures were "agreed" with the troika, but in practice the troika had little bargaining power.

Right Decision?

Was this the right decision?  It's a very close call and there are strong arguments on both sides of the debate, but on the whole it can probably be justified. The promissory note deal reached earlier this year should result in very substantial savings in 2014 (of the order of €1bn, as an estimate), and the vastly improved sentiment towards Ireland on the international financial markets means that Irish bond yields are unlikely to react much (if at all) to the smaller than planned size of the austerity measures. At a time when the Irish economy finally appears to be turning a corner, there is a case to be made to give the economy every help possible, in fiscal terms, by reducing the size of budget cuts as much as possible.

On the other hand, of course, Ireland's national debt is very large and is still rising - we will borrow close to €10bn next year, which will in practice be permanently added to the national debt and on which interest will have to be paid for generations to come.  In addition, if 'something goes wrong' in international financial markets, Ireland may once again be cut off from raising money in the bond markets and have to rely on international lenders such as the IMF and EU once again - and refusing to comply with their targets now might turn out to be costly if Ireland is forced to ask for further emergency in the future.

Taking everything into account the smaller austerity package was probably the better option.  But it is very likely something that can only be done once, for many reasons.  Firstly, the IMF has explicitly made it clear that it expects the shortfall from this year's budget to be made up in Budget 2015, i.e. adding the €600m of austerity measures that were not implemented in this budget to the austerity measures in the next budget. Secondly, the markets are likely to ' forgive' (if that's the right word) a budgetary shortfall in one year, based on the savings from the promissory note, but they are unlikely to be as relaxed if that happens again next year - that then becomes a trend, instead of a once-off event, and markets don't like to lend money to governments who ignore budgetary agreements and targets.

Betting on better growth

The government's hope, presumably, is that the emerging signs of recovery in the Irish economy are real, and deliver respectable economic growth in 2014 and still-stronger growth in 2015 - enough to deliver stronger-than-expected tax revenues and thus lower-than-agreed austerity measures in Budget 2015.  The government may well be right - many economic indicators are lining up in the right direction. But it is a risk, without a doubt.  If growth turns out to be disappointing next year and into 2015, the government is very unlikely to be able to avoid further substantial austerity measures in the next budget - and at least in theory, they could even be significantly larger than the €2bn that has been agreed already.

Jury is still out

So the government is taking a risk with this budget, privately hoping and expecting that better growth in 2014 and especially in 2015 will remove the need for extra austerity in Budget 2015.  It will probably require a growth rate of the order of 3% in 2015 to achieve that aim - a growth rate that does seem very high by the standards of the last few years, but one which is achievable, with a "fair wind", by 2015, if the international environment remains favourable. The consensus forecast for 2014 is a little short of 2%, and if that is achieved 3% in 2015 is not out of the question.  It will be quite some time before we know whetherteh government's calculated risk pays off or not.  As we said at the outset, the jury is still out!

 

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. If no austerity measures were introduced in the Budget, the deficit would have been 5.8% of GDP next year.
  • GDP is expected to grow by 0.2% this year, and 2% next year.  This is higher than the previous forecast of 1.8% (the figure endorsed by the independent Fiscal Advisory Council) due, the government says, to the measures in this budget which will increase growth next year.
  • The debt to GDP ratio will be 124% at the end of this year, but will fall to 120% by end 2014, 118.4% in 2015, and 114.6% by 2016.

Taxation:

  • The main income tax rates, band and credits are unchanged.
  • The pension  levy of 0.6% which was due to expire at the end of next yearwill first rise to 0.75% for 2014 and then fall to 0.15% from 2015 onwards.
  • Tax relief on pensions is being restricted. The standard fund threshold will be cut from €2.3m to €2m from the end of this year.  The current multiplier for converting a DB pension entitlement into an equivalent fund for the purposes of the cap is currently a flat 20 times, this is being replaced by a range of multipliers that will vary with age.
  • Changes will be made to ensure that no Irish companies can be "stateless" for tax purposes - this is a move clearly aimed to restricting the ability of companies to avoid tax both in Ireland and in other countries.  This has been a controversial issue in recent months for certain large multinational companies.
  • A "rollover" relief will be put in place for Capital Gains Tax for investors who invest proceeds of sales into new investments in certain productive businesses
  • Some investments in small companies will be exempted from the higher earners  cap on reliefs - basically giving the same tax advantages for high earners as are in place for middle income taxpayers who make this type of investment.
  • Tax relief on medical insurance is being restricted, with a cap so that the more expensive plans do not benefit from full tax relief. Tax relief will not apply on amounts greater than €1000 per adult and €500 per child.
  • Excise duty on cigarettes is up 10c
  • Excise duty on wine is up 50c per bottle
  • Excise duty on petrol and diesel is unchanged
  • Excise duty on a pint of beer or standard measure of spirits is up 10c
  • The DIRT tax rate is to rise from 33% to 41%, and the same rate will be applied to the exit tax on life insurance policies.
  • The VAT rate on tourism and hospitality related services, which was due to rise back to 15.5% from 9%, will remain at 9%.  In addition, the air travel tax will be abolished from April 2014.
  • An independent cost/benefit analysis will be carried out on the agribusiness sector to see which tax reliefs work and which don't.  Its recommendations will be considered in Budget 2015. 
  • In the construction sector, a new home renovation incentive scheme will provide a 13.5% tax credit for people carrying out work on their principal residence, for expenditure over €5000 and below €30,000.  In part, this is designed to squeeze the black economy as obviously the tax relief will only be available where a tax compliant builder is used.
  • An exemption from CGT for those who buy property and hold it for seven years is being extended to end 2014 (it was due to expire at the end of this year).
  • A new bank levy will raise €150m, levied in the same way as that levied from 2002 to 2005, i.e. essentially based on deposits. But the restriction on deferred tax assets for NAMA loses is being abolished.
  • A package of 25 measures, costing €500m in total, is designed to help business and create jobs, in particular in the SME sector will be introduced, including measures such as increasing the cash payments basis VAT threshold, a two-year tax holiday for long-term unemployed who set up a new business, and various other measures.
  • "Top slicing relief" on redundancy payments is being abolished.  This was a benefit which provided that people made redundant paid tax on the lump sum at their average rate of tax in the previous years, rather than their marginal rate.

Spending

  • Total spending cuts of €1.6bn out of total budgetary measures of €2.5bn.
  • Sick pay for employees will not apply to the first six days of absence.
  • The rate of unemployment benefit will be cut for claimants under 25
  • Other basic rates of social welfare will remain unchanged.
  • Medical card thresholds for the over 70s will be cut, reducing the number of pensioners entitled to a medical card by about 10%. On the other hand, free GP care will be introduced for all children under 5 years of age.
  • The telephone allowance for pensioners will be scrapped. 
  • The "death benefit" of €850 for next of kin to pay funeral expenses etc has been abolished.
  • Maternity benefit will be standardised at €230 per week, a slight reduction for better paid new claimants. 
  • Medical card prescription charge is up to €2.50 (from €1.50), with a monthly cap of €25.
     

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!

Q3 review

Before expanding further on the outlook, I will firstly provide a quick summary of the quarter just ended. After a pause for refresh during the second quarter, the third quarter of the year was a strong one for most assets, with the world equity market rising 6.4% in local currency terms which translated to 3.9% in euros, and the eurozone bond market showing a gain of about 1%.  This translates to a 14.2% year to date return in euros from global equities.  The gains were achieved as increasingly the global economy seemed to be making progress towards a more normal pace of growth: economic data released in the US showed reasonably strong growth, a widely-feared ‘hard landing’ in China failed to materialise, and the eurozone economy officially emerged from recession.  The decision in September by the Federal Reserve to continue without any change to its liquidity creation policies (i.e. the decision not to “taper” its pace of quantitative easing) was welcomed by the markets and emphasised how strongly policymakers around the world continue to pursue “pro-growth” policies. 

Positive outlook maintained

The recovery so far from the depths of the 2008 crisis can be best described as sub-trend with a very gradual acceleration of global economic growth. My continued optimism from here is centred on an expectation that we will see a further strengthening of growth over the next 12 months.  I forecast global growth of around 3.5% in 2014, up markedly from the 2.5% rate seen in recent quarters. While the economic growth outlook is encouraging it is also fair to say it’s in no way spectacular. Global profit growth of 6-8% during 2013 should be followed by slightly higher growth of 8-10% during 2014. As the baton passes from central banks to company profit growth, I expect that equity returns will increasingly be more in line with expected profit growth. This suggests returns over the next 12-18months should be less than achieved during the past 18 months.

Sovereign bonds have finally begun to struggle during 2013 and I forecast this to continue. “Yield rise” finally commenced during the first half of the year and I expect that bond yields will continue to rise as economic growth accelerates and in anticipation of central banks retreating from their current extraordinary positioning.  In the absence of any material acceleration in inflationary expectations, such “yield-rise” should continue to be gradual rather than explosive

Headline risks

Risks to my positive outlook are US politics, Fed tapering, Fed chairman succession and the emerging market outlook

As I write, US politics are in the headlines with the deadlock surrounding the debt ceiling debate a headline risk causing some short term market volatility. My central assumption is that a deal will once again be struck in Washington. Uncertainty and volatility may well dampen short term economic activity levels which in turn may well push Fed “tapering” into 2014 and therefore not something to be expected during the final months of 2013.

One of the major genuine shocks of recent quarters was the Fed’s decision in September not to “taper” or change the pace of “money creation” in the US economy. For many years now, the US Federal Reserve has gone a long way out of its way to carefully manage expectations of its actions. Over the next few weeks the full reasons behind the Fed’s surprising, even amazing, change of policy will become clearer. Until we know more, I welcome this change of policy in a somewhat guarded manner. If the US economy continues grow at a relatively strong pace, there is a genuine risk that the markets will see the Fed as being “behind the curve” in terms of preventing inflation in the future. The bond markets, in particular, worry most about future inflation. So – in this scenario – bond markets could sell off quite sharply and equity markets have a knee jerk negative reaction also. The prospect of tapering becoming a market issue over coming quarters is again likely.

Over the same time period we will also expect an announcement of the successor for Ben Bernanke as chairman of the Federal Reserve. The strong favourite is Janet Yellen who I believe will generally be welcomed by the markets.

Year to date developed equity markets have strongly outperformed emerging market equities. Emerging market equities were hit by outflows during Q2 in particular spooked by concerns of a Chinese hard landing and the negative liquidity consequences of Fed tapering.  I remain optimistic on emerging market equities.  Despite slower GDP growth from some countries, EM economies are still growing at a superior rate to developed economies and their equity markets are trading at large discounts to their developed market equivalents.  By their nature emerging markets are volatile and have historically been associated with periods where investors either love or hate them.

In summary, we remain in the recovery phase of the global economic cycle. To date central banks have been to the fore in aiding the recovery. From this point forward, valuations and profits will become increasingly central to market potential and outlook. As per the charts below, despite the strong returns since 2009 equity valuation remains on the cheap side of fair value.

Headline risks do remain and I expect markets to remain volatile on a quarterly basis. From a client portfolio perspective I continue to focus on higher quality companies, strong cash flow, and dividend paying companies as they should continue to be the winning factors driving stock selection.

 

 

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.

For many years now, the US Federal Reserve has gone a long way out of its way to carefully manage expectations of its actions.  Except in times of emergencies such as the failure of Lehmans, all its major policy moves were signposted well in advance.  Typically the Fed Chairman would give a speech or press conference outlining that a change in policy was being considered.  Then the minutes of the following Fed meeting would show that the committee had discussed the change in great detail, with a very strong hint that the change would be put in place at the next meeting.  Finally, the change would be implemented at that subsequent meeting.  It was predictable, transparent, and ensured that markets had plenty of time to digest significant policy changes and to understand why they were being made.

So when last May/June the Fed began to talk about “tapering” its monthly injections of liquidity, it set out on what seemed to be a very clear path towards actually beginning that tapering at its September meeting.  At no stage in the last several months, as the markets became completely convinced that that tapering would start in September, was there any effort by the Fed to tell the market that it was wrong to expect that.

Genuine shock

So it was a genuine shock when the Fed last night announced that it would not begin tapering this month, and might not begin next month either.  In a huge reversal of long-standing policy, it basically said, “never mind what we’ve told you to expect for several months, we’ve changed our mind.”  The immediate market reaction has been very positive – the $85bn per month of “money creation” from the Fed will continue, instead of gradually reducing.  That, at its most simple, means more money washing around the global financial system, and thus higher asset prices, all other things being equal.  Emerging markets in particular may gain from this impact, as they were clearly the worst affected in May and June when the Fed began to signal that it would start to taper.

Nothing is straightforward

However, nothing in the financial markets is entirely straightforward, and we would warn against excessive or simplistic optimism, for the reasons below:

• The Fed changed its mind about tightening policy because of “the tightening of financial conditions observed in recent months which if sustained could slow the pace of improvement in the economy.”  But that is a reasonably weak reason for such a significant change of mind.  Does the Fed know something that we don’t?  Might it conceivably be aware of a difficulty in some part of the US banking system, for example,  that the markets are unaware of?  That seems very unlikely but can’t be entirely ruled out.  Alternatively, is it aware of weakness (current or future) in the US economy that the markets are overlooking?  There are hundreds of economists working for the Fed around the US – if they are worried about the economic outlook, maybe we should be as well?

• "Markets hate uncertainty.”  And one thing that has definitely risen today, relative to yesterday, is uncertainty.  Before the Fed’s announcement we knew, or thought we knew, that the Fed was embarking on a straightforward, gradual “glide path” towards ending its monthly liquidity creation.  Yesterday we thought we knew why the Fed was doing that, when it was going to start and finish, and indeed what would happen after the process finished and what would have to happen before the Fed started to raise interest rates.  Today, we don’t know any of those things, and that increases risk and uncertainty in the markets.

• If the US economy continues grow at a relatively strong pace, there is a genuine risk that the markets will see the Fed as being “behind the curve” in terms of preventing inflation in the future.  The bond markets, in particular, worry about future inflation.  If the Fed is still creating vast amounts of liquidity while growth is quite strong, bond investors may think that they are risking a substantial build up of inflationary pressures in the economy that would be very damaging to bonds.  So – in this scenario – bond markets could sell off quite sharply.

Full clarity still to emerge

We believe that over the next few weeks the full reasons behind the Fed’s surprising, even amazing, change of policy will become clearer.  Until we know more, our welcome to this change of policy is somewhat guarded.  Our multi-asset portfolios are generally positioned to benefit from the Fed’s announcement and will benefit from the gains in the market following the announcement last night, but we do not propose at this stage to make significant changes to our allocations until the uncertainty reduces.
 

 

 

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.

 
At a most basic level, investors expect fossil fuel stocks to be a significant source of returns, providing access to a number of long term growth themes including resource scarcity, infrastructure investment and emerging market growth that are expected to drive investment returns for decades. We believe investors can access these secular drivers of growth in other ways. Energy demand will need to be met, but we believe investment in cleaner, more efficient energy solutions have better long term prospects given the need to meet demand while reducing GHG emissions. While the demand for energy is one key example of resource scarcity, water and food are even more essential resources, and their demand is also expected to accelerate through mid century. Most of this growth in demand across all three vital resources is being driven by population growth and changing demographics in emerging market countries as they industrialize and grow. Essential infrastructure investment to meet the increase in demand and more efficiently manage resource provision will need to be made across water, food and energy in both the developed world and emerging markets.
 
To date, most institutional portfolios have been underinvested in stocks providing solutions to the need for low carbon energy, food and water. Instead of investing in fossil fuel stocks, companies providing renewable energy, energy efficiency, water and agribusiness can be viewed as replacements for the drivers of growth expected from traditional energy stocks. We believe that when the risks and rewards are fully considered, the opportunity for investment across these 4 areas is stronger than investment in conventional energy stocks.
 
Energy demand is expected to grow by 33% by 2030 alone, but given the carbon emissions of fossil fuels, renewable sources and more efficient uses of energy will need to grow if we are to avert the worst implications of climate change. The International Energy Agency estimates that $16.9 trillion will need to be invested in power generation, transmission and distribution and more than 75% of this investment will be in renewable generation and higher capacity, more efficient transmission and distribution. This capital will be deployed in the development of renewable technologies as well as technologies and infrastructure for increased energy efficiency, providing a wide opportunity set of diverse companies in which to invest.
 
While renewable energy stocks suffered in the immediate wake of the global credit crisis, we have seen the beginning of what we believe will be a sustained, strong, recovery. With the costs of wind and solar continuing to decline, it’s reasonable to expect they will help reduce the reliance on fossil fuels over the next ten years. There will also be a renewal of pressure on policy makers to accelerate the path to a low carbon economy as more people comprehend the implications of not reducing carbon emissions and continue to experience first hand the consequences of rising global temperatures through extreme weather. Any policy movement in this direction would support renewable and energy efficiency stocks relative to conventional energy stocks.
 
Investing in companies providing water solutions can also access strong investment returns driven by resource scarcity, emerging market growth and the need for infrastructure investment. Water is our most vital resource, not only for sustaining life, but also for economic growth as an essential input across many industries. It is a finite resource, and unlike oil, there is no substitute. Less than 1% of the world’s water is available for use and this limited supply is increasingly threatened by pollution, particularly in emerging market countries as they grow and industrialize.
 
Historically, water demand has grown at twice the rate of population and is expected to grow by 41% by 2030. An estimated $22 trillion investment will be required to meet the need for water through 2030, which is expected to be the largest component of global infrastructure spending through 2030. This extensive capital commitment will be deployed through companies working to provide solutions.
 
Similarly, agricultural solutions providers will also be driven by resource scarcity, emerging market growth and the need for infrastructure investment. The supply of arable land for farming is relatively fixed, with approximately 38% of the earth’s land currently used for farming. Demand for food is expected to expand by at least 70% by mid century, largely driven by economic growth in emerging markets. In order to meet the demand for food, we will have to find ways to dramatically increase crop yields and distribute produce more efficiently, which will require massive investment in companies providing machinery, precision agricultural technology and infrastructure. An astonishing 30% of the food produced across the globe goes to waste as lack of adequate infrastructure to handle and transport produce is a key constraint in both developing and developed regions. The Food and Agricultural Organization (FAO) estimates that in the developing world alone, $9.2 trillion in investment will be needed to meet agricultural needs through 2050.
 
There are also more significant risks to conventional energy stocks. John Fullerton of the Capital Institute reports that limiting the rise in global temperatures to two degrees Celsius will require stranding of fossil fuel reserves with an economic value of approximately $20 trillion, creating a potentially devastating shock to the global economy and a huge liability for the entire conventional energy sector. The problem is that current investment horizons are not adequately taking these risks into account. But given the actual long time horizons of most institutional investors, should not these risks be given some probability? And once these risks are accounted for, will not stocks of companies providing renewable energy, energy efficiency, water and agribusiness solutions prove more compelling on a risk/reward basis? Even moving a portion of assets from conventional energy stocks to low carbon energy, water and agribusiness stocks will enable investors to not only retain exposure to sources of growth, but also create a natural hedge against carbon related liabilities.
 
Investors need to incorporate the longer term risks embedded in fossil fuel stocks as they develop their equity strategy for the next ten years and consider accessing the same drivers of growth through other areas of the equity market. While an immediate wholesale move out of traditional energy stocks may not be practical or prudent, investors need to develop a plan for managing exposure to the risks of fossil fuel stocks and identifying alternative investments that provide exposures to attractive returns from growth drivers of resource scarcity, infrastructure investment and emerging market growth. This could involve a carefully constructed plan for divestment that manages costs of divestment and weighs the opportunity to influence change at big oil companies through active engagement. We believe It should also involve exploring increasing exposure to water, agribusiness, renewable energy stocks and clean tech companies providing energy efficiency solutions.
 
Such a well constructed plan would be in the best long term interest of both institutions and our planet.
 
 

References

1 McKinsey Global Institute, Resource Revolution: meeting the world’s energy, materials, food, and water needs, Nov 2011
2 Research, Citi Climate Change Universe; 20 top picks with exposure to the $37 trillion energy transformation, March 2013
3 McKinsey Global Institute, November 2011
4 Jacobs Securities, Global Water Primer, April 2011, referencing Booz Allen Hamilton
5 Jonathan A. Foley, “Can we feed the world and sustain the planet?”, Scientific American, November 2011
6 Goldman Sachs, “Rain and grain, hard to sustain,” Fortnightly Thoughts, 25 August 2011
7 FAO, Food Security and Agricultural Mitigation in Developing Countries: Options for Capturing Synergies, 2009
8 Capital Institute, “The Big Choice”,19 July 2011, http://capitalinstitute.org/blog/big-choice-0

 

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