by Andrew Merricks - Head of Investments, Skerritt Consultants. December 2008

THE PROFESSIONALS’ VIEW – DECEMBER 2008

If You Say So, Darling:

So now we know how to get out of debt.  Borrow more.  This seems to be the Chancellor’s preferred method of steering the Nation away from the credit-crunched rocks upon which the world threatens to founder.  The recently elected Mayor of London rather unkindly likened Mr Darling, in the Standard on the day of the Pre-Budget Report, to “a sherry-crazed old dowager who has lost the family silver at roulette, and who now decides to double up by betting the house as well.”  An analogy too far perhaps, but one does wonder whether he got home from the Commons early one day and was tempted by one of those daytime TV adverts that offers to “consolidate all your loans into one easy payment”.  Has that ever worked for anyone? We have no other option at this stage other than to cross our fingers, toes and anything else we can find to cross and hope that we do not slide into an even deeper mess than we are in today.

“Fears Of Defaults On UK Gilts Rise”:

This was the unimaginable headline in the Telegraph on Wednesday 26^th November. If there has been one place that investors could have 100% certainty for their capital since the domino-tumbling events that struck the global banking system in September, it has been in UK Government Bonds, or gilts as they are better known.  Since they were first issued in 1694, not once has our Government defaulted when it was time to pay investors back their cash.  But on the day of the Pre-Budget Report, the cost of insuring against a Government default on its debt – through what is known as a credit default swap – rose to 100 basis points above Libor, significantly higher than the 58.8 points for BNP (no, not that BNP whose list of members found itself in the public domain, but the Paris-based bank), 65.2 for Commerzbank and 68.6 for Credit Agricole. 

Even HBOS was priced at 99.2, but then the old Halifax is the Government these days isn’t it? 

So How Safe Are Gilts?:

As we said, gilts have been the one safe haven for risk averse investors, but are they any more?  We would say that on balance, they are – but they come at a cost now, as well as a wealth warning. 

History tells us that when there has been a surge in prices in any asset, the downside risk for new investors is heightened.  When there is too much of something in relation to demand, the price of that asset tends to fall.  In other words, what goes up can come down.  If the thing that is coming down in price is not expected to do so, it can cause nasty shocks for those owning it.

The Treasury is seeking to issue an unprecedented £146.4 billion of gilts in this fiscal year.  If you’re selling something, you need a buyer willing to match the price at which you are offering it. Who is in the market for this amount of gilt issuance? Traditionally it has been institutions such as insurance companies who need to match their liabilities for those of us looking to retire in the future, and overseas countries who reckon that the UK is good to stand their loans.  Are the buyers still out there for this quantity of supply though?  Probably.

But how risky are they for smaller investors buying into them now in search of safety of capital? 

Prices Look “Toppy”:

So what do you get for your money in the gilt market at the moment?  According to M&G, who are well respected in the fixed interest sector, 10 year gilt yields hit an all-time low on Wednesday 27^th November.  Putting this another way, if the yield on gilts hits an all-time low, the price of those gilts has hit an all-time high. As a rule of thumb, it is not the best tactic for maximising capital return to buy something when it has never been so expensive.  But then markets overshoot all the time, whether they are going up or coming down.

In June 2003, pretty well at the very turning point of the stock markets from the 3-year slump they had experienced since 2000, 10-year gilts yielded 3.86%.  On November 22^nd just gone they were yielding 3.79%.  As recently as mid-October this year, investors were receiving 4.7% from that same asset.  The price of gilts has risen by 16.3% since the beginning of July 2007.  The big question now is, will buyers at these rates of return still be found to mop up the forthcoming issuance? If not, should those already owning them be sauntering towards the exit to try to beat the rush when it comes?

This all depends upon where interest rates are heading.  If, as widely forecast, they continue to fall, the plus 3% return will look attractive.  If, as some are forecasting, interest rates fall to close to zero per cent, plus 3% will look positively mouth watering.  So despite market awareness of the up and coming huge supply of gilts, and doubts about the Treasury’s growth projections, fears of deflation and a prolonged period of interest rates being closer to zero than they are now are outweighing current pricing concerns and gilts continue to rise in value and their yields fall.  In M&G’s words, “the prospect of deflation, and particularly the chance of prolonged deflation, means that the rally (in gilts) may have much further to go.”  We may agree, but the warning signs are flashing that this “safe haven” may have a nasty surprise in store for those who expect security at any price.

Is Anything Safe?:

It is difficult to categorise anything as “safe” right now, but an interesting case has been made for gold in recent days.  Anyone who invested in gold when it was trading at over $1,000 an ounce will bear witness that its current price of around $800 an ounce shows that it is far from being a one way bet, but US bank Citigroup make an interesting case for it against an “either-or” consequence of policy makers’ chosen route to recovery.

They argue that the pumping of cash into the markets by the authorities around the globe will end in one of two extreme ways.  Either there will be a resurgence of inflation or we will embark upon a downward spiral into depression, civil disorder and possibly war.  Tom Fitzpatrick, chief technical strategist at Citigroup, explains.

“When the dust settles this will either work, and the money they have pushed into the system will feed through into an inflation shock.  Or it will not work and…we will see further economic deterioration. This will lead to political instability.  We are already seeing countries on the periphery of Europe under severe stress. Some leaders are at record levels of unpopularity. There is a risk of domestic unrest, starting with strikes because people are feeling disenfranchised.” Both outcomes will cause a rush for gold.

Add to this reports that China is thinking of boosting its gold reserves from 600 tonnes to nearer 4,000 tonnes to diversify away from paper currencies and the potential of buying into gold at its current price is clear.

As always, personal goals and situations make a difference, so if you need someone to chat to about your existing investments, please do feel free to contact us.

These are our views and are for professional use only.