Markets are once again being driven by events in Europe. .…..
Robert Farago, Head of Asset Allocation
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For professional investors and advisers only
Europe heading into recession
halving our growth forecast for 2012 (from 3.4% to 1.8%) but still expect expansion in the US, Japan and the emerging world.
Bank shares fall sharply
“We cannot accept the explosion of the euro, which would mean the explosion of Europe.
The problem must be posed in this fashion, and not otherwise. If the euro is the core of Europe, the explosion of the euro would blow up Europe. And Europe is the guarantee of peace on the continent where people have behaved in the most brutal and violent manner of all continents of the world – not in the 15th century, but in the 20th century. It is
perfectly normal that two founding countries of Europe [France and Germany], and the two largest European economies, should take up the front line to defend a European heritage that has been bequeathed to us by our predecessors. The crisis of the euro is one of the most important crises that Europe has known since its creation.”
French President Nicolas Sarkozy, 3rd November 2011
For the world as a whole, the price of a disorderly break-up would be a deep recession. It would also wipe out much of the capital of the banking system in Europe, leading to a number of banks being nationalised. It is this stark reality that leads us to believe that we have not yet reached the point where governments are ready to walk away from the euro.
The economic reality is that the fate of the euro will be decided in Germany. The current account deficits of Italy, Spain, Portugal and Greece are offset almost exactly by a surplus in Germany equivalent to about 5% of its GDP.
It is Germany that has the financial strength to support their weaker neighbours. It will decide if the reforms proposed by the peripheral nations, and in particular Italy and Spain, are sufficiently credible such that the German government can face their electorate and explain that this support is both necessary and to Germany’s long-term advantage.
Stagflation protection
The fall in long-term government bond yields to yields below our long-term inflation expectations means that a buy and hold strategy is also likely to lead to negative real returns. A real yield on index-linked bonds of around zero over the next ten years does not sound appetising either but is attractive relative to both cash and fixed interest securities. In
addition, they offer protection should the authorities’ inflationary policies eventually bear fruit, which we see as inevitable in the long-term. We have invested in US Treasury inflation protected securities as the real yield is higher than in the UK, the dollar is undervalued on a purchasing power parity and inflation expectations have fallen over the
last few months. The ideal scenario for these instruments would be a combination of high inflation and low real interest
rates. This is, unfortunately, a likely outcome since economic growth is expected to remain muted and unemployment is likely to remain high.
Disclaimer:
For professional investors and advisers only.This document is not suitable for retail clients.
This document is intended to be for information purposes only and it is not intended as promotional material in any respect. The material is not intended as an offer or solicitation for the purchase or sale of any financial instrument. The material is not intended to provide, and should not be relied on for, accounting, legal or tax advice, or investment recommendations. Information herein is believed to be reliable but Schroder Investment Management Ltd (Schroders) does not warrant its completeness or accuracy. No responsibility can be accepted for errors of fact or opinion. This does not exclude or restrict any duty or liability that Schroders has to its customers under the Financial Services and Markets Act 2000 (as amended from time to time) or any other regulatory system. Schroders has expressed its own views and opinions in this document and these may change. Reliance should not be placed on the views and information in the document when taking individual investment and/or strategic decisions. Issued by Schroder Investment Management Limited, 31 Gresham Street, London EC2V 7QA, which is authorised and regulated by the Financial Services Authority. For your security, communications may be taped or monitored.
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