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Vision 2013


May I welcome you all to this first edition of Vision from Investec Wealth & Investment. 2012 was a transformational year for us, with our successful integration of Williams de Broë taking our national network of offices in the UK to 15 and our assets under management to around £20bn (source: Investec Wealth & Investment).

To Infinity and Beyond

Demographics and Future Stock Market Returns

Banking on a Positive 2013?

Ahead in the Clouds

High Yield Bonds: Moving into the Light

Fossil Fuel Sunset?

In Defence of Defence

Rare but not Endangered

Welcome to Vision 2013

May I welcome you all to this first edition of Vision from Investec Wealth & Investment. 2012 was a transformational year for us, with our successful integration of Williams de Broë taking our national network of offices in the UK to 15 and our assets under management to around £20bn (source: Investec Wealth & Investment). Vision has been one of Williams de Broë’s flagship publications since 2008 and we are delighted to be able to carry it forwards as a valuable addition to our own offering. Last year was one of tremendous challenges. Arguably one of the greatest of these was within our own industry, where the Retail Distribution Review (RDR) is now fully in force, leaving the world of financial advice better trained, better qualified and more transparent. Indeed these principles and standards that underpin the RDR have always been at the heart of our approach to doing business and it is our firm view that the outcome will benefit all parties involved, from investment managers to financial advisers, other professional intermediaries and of course all our clients. Financial markets were remarkably robust, with global equities performing well in spite of an undoubtedly challenging environment. As you will discover as you read through Vision, we are cautiously optimistic that this year will be another good one for equity investors. The world is slowly but steadily creating a path to economic and financial stability. With returns on cash and other ‘safe’ investments likely to stay below inflation for some time to come, the need to invest sensibly and with the utmost professionalism has never been greater. I am proud to say that these are all core principles of how we do business at Investec Wealth & Investment.

Tom Street
Head of Investment Management


It was with a degree of fortitude that we predicted 2012 would be a good year for investors. But that bravery has been well rewarded with the majority of allegedly ‘risky’ asset classes notching gains well in excess of inflation over the course of last year. ‘Safer’ assets typically fared less well but still tended to return absolute gains.

On the face of it this is surprising – the Eurozone crisis lurched from acronym to acronym, economic growth slowed globally and corporate profits finished the year looking decidedly peaky. Yet equity markets continued the rises that started way back in March 2009 and bond yields for both core and so-called peripheral countries fell. So either this was another year in which hope has triumphed over reality or else markets are signalling that something is changing. While we are not yet furnished with sufficient bravado to rule out the former, the odds, in our view, strongly favour the latter. 2013 brings its own set of new challenges for markets but we are again optimistic that the year ahead could ultimately be rewarding for those prepared to ‘put their money to work’.

Every discussion of last year’s developments and this year’s prospects should start in Europe. In the years since the great financial crisis of the latter part of the last decade it has been the public finances of the member states of the Eurozone that have been seen as the great stumbling block.
We suspect that to a large degree this has been the need of markets to have a bogeyman. The initial cause of the crisis – over-leverage of American banks on sub-prime residential real estate – has long since passed but has left a persisting legacy of trauma. Once bitten twice shy markets have become nervous and distrustful, needing to believe that something somewhere is terribly wrong. And the Eurozone has fitted the bill perfectly.

Before we delve too deeply into the woes of Continental Europe we want to add what we believe is a slightly different perspective. In our opening remarks we have referred to the ‘Eurozone crisis’ and ‘markets’ as if they are inextricably linked. This is open to considerable doubt. There are undisputed crises in political ranks, in central and national banks and on the streets of Greece and Spain. We question however whether the ‘crisis’ is still manifest in financial markets. Global equity progress through 2012 was really rather serene; the Vix Index, a measure of volatility that is widely touted as ‘the fear index’, spent most of the year at or below its lowest levels since mid 2007, while the drawdown (fall from peak to trough) of the S&P 500 Index, still the most important in the world, was only 9.5%, as compared to 19% in 2011 and 16% in 2010.

Once bitten twice shy markets have become nervous and distrustful, needing to believe that something somewhere is terribly wrong. And the Eurozone has fitted the bill perfectly.

Neither have bond markets been especially perturbed. The yield of the German benchmark 10 year maturity bond varied between only 2.06% and 1.17%, while the supposedly stigmatised Spanish 10 year yield peaked at 7.62% in July (before falling back to below 6%) versus a low of 4.85% (source: Bloomberg) at the start of February. These are all signs to us that the ‘crisis’ is of greater lingering interest to the commentators than it is to ‘markets’.

We do not wish to pretend that there are not very real and important issues being played out from day to day. For example, it is still totally unclear whether and for how long Greece can or will remain a member of the single currency. It is just as uncertain whether the Spanish banks will require even more capital to maintain their solvency in the face of their enormous losses on property loans or how any of the centrally provided funding will rank relative to any other loans or bonds. But these are ‘known unknowns’ that the markets have had ample time to digest; they still have the potential to unsettle markets for a while, but their firepower is mostly spent and we expect that the inescapable set-backs will be short and shallow.

We doubt very much whether outright austerity will succeed in addressing the underlying issue of excessive government expenditure being supported by insufficient income from taxation. Austerity attacks only one side of the equation, it does nothing to increase government revenues and its lowering of economic activity arguably only exacerbates the problems. An alternative approach that we think is worthy of consideration is for tax cuts, which have frequently proved to be a mechanism for both promoting growth and actually raising receipts. It is currently an isolated and minority view but as the austerity policies are steadily discredited it may become an increasingly widely advocated prescription.

Once everyone is reassured that someone is ‘good for the money’, then everyone can get back to making normal commercial banking decisions rather than worrying if they will ever get their money back from all the sovereign bonds in the vaults and all their derivative counterparties.

We thank Mario Draghi, the President of the European Central Bank (ECB), not only for his extension of ghastly financial acronyms but primarily for having created a degree of stability from the wreckage inherited from his predecessor. He has a handy knack for delivering precisely what markets believe they need, with each successive addition to the list of jargon as ‘a game changer’. The first of these was the LTRO, or Long Term Refinancing Operation. There is a degree of latitude here as ‘long term’ equates to three years, but the key feature of this essential addition to the Eurozone’s financial armoury was that it provided a guarantee of liquidity to the region’s banks. If a bank needed it, the ECB would lend it as much money as it required at a token rate of interest. The intended and successful side effect of this is that it ensured a ready supply of money for banks to use to purchase new sovereign debt issues.

The two LTROs seen thus far though have been insufficient in themselves. They have needed to be supported by OMTs, or Outright Monetary Transactions. OMTs provide the wherewithal for the ECB to act as buyer or last resort for Eurozone sovereign bonds. This is a blank cheque with conditions, whereby the ECB will purchase infinite numbers of bonds if the country in question is prepared to wear sackcloth and ashes, sit on the naughty step and submit to some Germanic economic discipline.

The conditions will create problems, but these arguments are part of the fabric of the Eurozone. They will upset markets from time to time, but not to the same extent as in the past and if Europe has not exactly been put on the path to wealth and prosperity, the chances of it all falling apart look highly remote. That the LTROs and the OMT effectively underwrite the Eurozone’s banks and sovereign bonds means Europe can at last get on with trying to find policies that will promote growth.

We worry just as much as anyone else about the longer term inflationary problems should the ECB ever to be called upon to use the full extent of its powers. Finite amounts of money will ultimately inflate asset prices, let alone infinite sums. The key however is confidence. The ECB’s powers are a financial nuclear deterrent; it should be sufficient just to know that they are there and their mere existence should ensure that the ECB is not called upon to use them to their full extent. Once everyone is reassured that someone is ‘good for the money’, then everyone can get back to making normal commercial banking decisions rather than worrying if they will ever get their money back from all the sovereign bonds in the vaults and all their derivative counterparties.

The UK’s lifeboat is that the global economic cycle is turning up and 2013 will see higher growth, higher equity markets and a firmer housing market, all of which the Government and Bank of England will take credit for.

The United States, in contrast, has been less problematic. This time last year we were arguing that economic recovery would be underpinned by what we saw as a firmly based recovery in the housing market. And so it has proved. Admittedly the economy slowed over the second half of the year as its export markets in Europe and Asia did likewise, but not dramatically so. The much watched survey of Manufacturing by the Institute of Supply Management (ISM) dipped below the level of 50 that is meant to signify the dividing line between growth and contraction (the reality of the survey is slightly more complex) but only briefly, while the same ISM Survey of the Services Sector remained resolutely in growth territory all year. Most encouragingly the latter stages of last year saw both surveys strengthening.

The missing ingredient in the recovery in the American economy since 2009 has been job creation. According to the monthly non-farm payrolls the economy has been creating around 100,000 jobs per month, a number widely regarded as struggling to keep pace with the natural demographic increase in the workforce. Unlike the Bank of England, whose economic remit is limited to an inflation target, the Federal Reserve Bank is additionally tasked with maintaining full employment. 2012’s unemployment rates of between 8% and 9% have clearly been inconsistent with this and last September’s announcement of a third round of quantitative easing (QE) was no surprise. QE3 has been dubbed QE Infinity as it pledges to buy a maximum monthly amount of $40bn of bonds and other securities until such time as unemployment falls to a level with which the Federal Reserve is comfortable. As with the ECB this is a potentially never-ending and infinite process. Unlike the ECB however, it is in much greater danger of being used. Until such time that the US economy is consistently creating in excess of a quarter of a million jobs every month, the Fed will have to make these monthly bond purchases. Our typically terribly simple arithmetic tells us that if this takes a year, which seems a reasonable timescale with a strong following wind, this will add up to another $480bn added to the Fed’s balance sheet.


This is a potential problem. We do not think that American banks are undercapitalised nor unnecessarily restricting credit and we are thus inclined to think that QE3 is possibly unnecessary. We have no more idea than anyone else (which is nothing anyway) how global quantitative easing will be eventually unwound, but we suspect that logically the larger the amounts added to the central banks’ balance sheets, the larger the problem. Our expectation is that the monetary growth resulting from quantitative easing will create inflation of asset prices rather than of goods and services in the first instance. More specifically this means we think that inflation will be manifest in equities and house prices as opposed to the high street.

The United States also faces the so-called ‘fiscal cliff’, a rather dramatic term coined by Ben Bernanke with the aim of focusing political attention on the need to deal with a potentially unpleasant combination of circumstances. The challenge is that over the first half of this year tax cuts expire from both Obama’s emergency stimuli and from President Bush over a decade ago. Dependent on precisely how these are calculated they account for roughly $600bn, or 4% of GDP. The problem is not so much that they cannot be dealt with – they can easily be rolled over – but that there is so much political capital to be made from the horse-trading between the two parties. If this does end unnecessarily in tears it will be a tragedy of human making. We are rather taken with an analogy (not ours) between the fiscal cliff and the millennium bug – greatly feared but ultimately a non-event.

Returning to the United Kingdom we wholeheartedly applaud the Funding for Lending Scheme. We had long been sceptical about the efficacy of the UK’s quantitative easing programme, with much of the potential benefit being immediately negated by the Bank of England’s insistence that the high street banks hoard capital. As we argued in last year’s Vision we believe that the panic recapitalisation of the banks was a major contributory factor in the alarming shrinkage of the broad money supply, which in turn was the root cause of the 2012 recession. Quantitative easing, in our view, failed to address this. The Funding for Lending Scheme, whilst by no means perfect, is likely to be a much more productive angle of attack and the early signs have been highly encouraging, especially with regard to mortgage lending. Confidence, and the lack of it, is easily turned into a self-fulfilling prophecy. A belief in worse times ahead leads to a constriction of credit, which in turn will help to create the very problem feared in the first place. In the same way confidence begets confidence. If the banks start to believe that the global economy is about to turn up, then they will use the Funding for Lending Scheme.

Counter-intuitively 2013 will also benefit by not having the Olympic Games. The Olympics had an inverse effect on the economy: the better the Games, the more we all stayed at home to watch the BBC. It is impossible to quantify the detriment to the economy, but the impact on retail sales will have been material, as will the disruption to the day to day running of the economy caused by the distractions of both Games. Similarly the absence of Jubilees will add to this year’s output.

So 2013 promises to be a much better year for the UK economy. Having unfortunately been right in our prediction that 2012 would be a year of recession, we are now confident that this year will bring positive surprises. This may also bring temporary respite to the Coalition Government; aside from the Funding for Lending Scheme the UK’s government gives every impression of having run out of ideas of how to tackle its mounting challenges. We take no pleasure in pointing out that if our debt to GDP ratio were calculated on the same basis as Italy it would stand at an horrendous 144%, versus the Italians’ mere 120% (source: Capital Economics). The UK’s lifeboat is that the global economic cycle is turning up and 2013 will see higher growth, higher equity markets and a firmer housing market, all of which the Government and Bank of England will take credit for.

There is only so much that the developed world can do to stimulate endogenous economic growth. It needs to be helped by the emerging economies, most notably China and India. The signs for both countries are better. With regard to the former, the latter stages of 2012 were undoubtedly affected by political bottlenecking. The end of the five year political cycle in the run up to last year’s 18th Party Congress was considerably hampered by Bo Xilai’s connection to the murder of Neil Heywood.
The ousting of the former leader of Chongqing created additional tensions between the factions in the Communist Party (old school versus reformists, and East Coast versus Western China). Whilst it has been known that Xi Jinping would become President and Li Keqiang would follow Wen Jiabao as Premier, the makeup of the remainder of the Politburo Standing Committee was open to considerable doubt. The knock-on effect to the economy was caused by an understandable reluctance among businesses and investors to commit to new enterprise at a time when the fabric of the Communist Party was unknown. With the resolution of this we are hopeful that 2013 will be a time of debottlenecking and an acceleration in China’s economic growth rate.

India, the other great emerging economic superpower, is also entering a political cycle, albeit the next elections are not due until 2014. Prime Minister Singh has become increasingly unpopular and has been struggling to hold together his coalition government. The root cause of popular dissent is corruption, whereby India’s prodigious wealth creation sticks in the hands of a few rather than benefitting the whole country. Singh needs to try to improve growth and wealth creation this year, a task that is considerably easier said than done in this notoriously bureaucratic country. But there are signs of hope, especially a more open and flexible attitude towards direct foreign investment.

We feel that this all starts to make 2013 look like a potentially very attractive year for investment. The likely icebergs, or bumps in the road, are as Donald Rumsfeld so aptly described ‘known unknowns’. Markets have had years to analyse and digest the possibilities and long since moved on. Central Banks have flexed their potentially infinite muscles, confidence is creeping back in, bank profits are rising, the US housing market is firm, credit conditions are easing, money supplies are rising and global growth this year ought to be nicely higher than last year. Corporate profits will similarly increase after a poor year in 2012, while equity valuations remain at multi-decade lows relative to bonds.


If we are right in supposing that we are in the midst of an equity bull market that began in March 2009, then we are probably around half way through.
Bull markets (and bear markets) are characterised by disbelief during the first half (but everything is still so bad/good), followed by a gradual process of capitulation. Surveys have repeatedly told us that the average institutional investor is still underweight equity relative to their benchmark, suggesting that the same average institution is underperforming. This is still the greatest incentive for many to change an asset allocation, especially at a time when despite such universal and persistent misery amongst investors and commentators alike, the returns from equity markets since the first quarter of
2009 have been nothing short of spectacular. This is a party that will become more and more popular.

We thus go into 2013 with a reinvigorated sense of opportunity and optimism. In a world addicted to headlines, global growth will steadily improve without ever threatening to set the world on fire. Inflation will remain low, meaning that monetary policy will stay exceptionally loose and upwards pressure on bond yields should be minimal. America will not be derailed by the fiscal cliff, China’s growth will be boosted by the handover to the new regime, the UK has crawled back into growth and even Europe is out of intensive care. The great financial crisis started in the autumn of 2007; in 2013 it is time to move on, to QE infinity and beyond.

There is only so much that the developed world can do to stimulate endogenous economic growth. It needs to be helped by the emerging economies, most notably China and India.


The two concerns can be distilled to whether we are finally reaching the point of global population saturation and separately, even if this is not the case, whether the developed world is ageing too fast to sustain further growth or generate attractive investment returns.


The majority of investment analysis is focused on understanding the day to day opportunities presented by asset markets. Is this share cheap? Is the economic cycle overheating? The study of the impact of demographics on asset prices stands out by exception. How changes in the size and mix of population affect a country’s economic development is a secular, not a cyclical conundrum that has exercised minds for centuries. This is also an area that has gained increasing focus over the last 10 years for two key reasons, both of them frequent sources of concern in the media and for investors.

The two concerns can be distilled to whether we are finally reaching the point of global population saturation (the world has too many people) and separately, even if this is not the case, whether the developed world is ageing too fast (we have the wrong sort of people) to sustain further growth or generate attractive investment returns.

Too many? The combination of more than a decade of broadly rising commodity prices and apocalyptic visions of the effect of climate change on food supplies are thought by some to signal that we are close to seeing Malthus’ dire predictions vindicated. They fear that global resource supply cannot cope with the twin demands of the continued rise in the global population, (which last year passed the 7bn mark) and the increasing intensity of resource utilisation in the Emerging Economies. The resulting price rises in basic commodities, it is believed, will increasingly act as a check to global growth (even the most dynamic parts of it) in much the way Robert Malthus suggested in his 1798 paper “An Essay on the Principle of Population”. It is important to understand that from an investors’ perspective this is bad not because economies in this situation do not grow in absolute terms – they do so in a cyclical pattern as supply ultimately responds to the demands of the enlarged population – but because of the fact that the world becomes no more productive (wealthy) on a per-capita basis as population growth immediately soaks up (and frequently runs ahead of) supply growth. It is not headline economic growth but productivity growth that matters to investment returns, as the history of many developing nations bears witness over the past 150 years.

Our view is almost diametrically opposed to that of the pessimists – a population of 7bn and growing is something to be celebrated, not feared. The two reasons why Malthus was wrong in 1798, when the world contained just one seventh the number of people that it does today, remain valid now. Malthus misunderstood the role of prices in stimulating supply whilst simultaneously underestimating the power of technology to increase it. There are two pieces of evidence that suggest that these positive forces remain effective. The first concerns the price signals given by commodity markets. The opening decade of the new millennium showed poor stock market returns and rising commodity prices – a textbook Malthusian warning signal. A look at the longer term relationship between stock prices and commodity prices however suggests that the most recent experience is consistent with previous mini-cycles in the longer term (Malthus confounding) patterns of stock markets outperforming commodities.

The chart above which is reproduced courtesy of Stifel Nicolaus’ exceptional investment strategist, Barry Bannister, shows this pattern by plotting stock prices relative to commodity prices in America since 1870. In this graph, a rising line signals stocks outperforming commodities, a falling line shows the reverse. Note the similar duration of the periods of commodities outperforming stocks (10-15 year cycles) followed by longer periods of stocks outperforming commodities. Those with good eyesight will also note the most recent resumption of stock prices outperforming commodities – signalled by the last upwards flick in the line.

The second piece of evidence is less specific, but is one of common sense. We contend that the technological revolution over the past decade has been as profound as at any time in the past century and would be surprised if the scientific advances of even the past 20 years are not up to the challenge of providing for the growing numerical and aspirational needs of the world’s population. The evidence is already compelling in the energy sphere, where technological advances have enabled the discovery and exploitation of hitherto unreachable resource basins, whilst new production methods have both revived the productivity of depleted oil wells and unlocked a vast new potential source of gas in shale rock formations. Think too of genetics applied to man, beast and crops, of innovative cultivation techniques (bio skyscrapers & marine farms are both on the drawing board), alternative sourcing and of nanotechnology opening up huge vistas of both resource conservation (solar power) and in lifestyle enhancing opportunities (medicine).

Finally on this point, projections of future population indicate that we are already past the greatest incremental strain on resource supply, with growth rates expected to decline materially in the future. The world coped with adding 4bn people in the past 50 years, it can almost certainly cope with adding under 3bn in the next, at which point some surveys project a natural peak due to declining fertility. In the midst of an economic slump that many attribute to too much supply, it is a challenge that investors should welcome.

Now to address the second demographic concern frequently raised by investors – is the world ageing too fast for shares to make attractive investments?

Ageing is an issue not just for the developed world, but this is where the question is most pressing. Once again we are optimists, but our view is more nuanced. To answer the question, we must understand what effect the anticipated demographic evolution of the developed world will have on both corporate earnings power and also upon the likely valuation of those earnings.

Looking first at the anticipated valuation impact of the coming shifts in the demographics of Europe and America. There have been a number of academic studies to determine to what extent historic American stock market valuations can be explained by the so called “life cycle” theory of investment. In simple terms, in this model different age profiles are deemed to have different saving habits. “Young” workers save little but spend a lot. “Middle Aged” people spend a lot (to sustain families) and save a lot (for retirement). “Old” people spend less and actually dis-save (draw down retirement savings). The theory is that, since savings drive stock prices, when populations have high shares of
“Middle Aged” people relative to the young or the old, the valuation of their stock markets is high.

For America at least, this does in fact appear to be the case. Here we show a chart produced by researchers at the San Francisco Federal Reserve overlaying the ratio of “Middle Aged” to “Older” people (The “M/O” ratio – the pink line) with the Price Earnings ratio of the American stock market (the P/E ratio – the blue area).

The relationship looks close and somewhat alarmingly, projecting forwards for anticipated population development would suggest the Price Earnings valuation multiple (P/E) of the US market could fall from the current level of 14x to just over 8x in 2025. Looking at a similar ratio – the old age dependency ratio 2 – in North America, Western Europe & Japan, assuming that a similarly rising ratio implies a similarly falling P/E impact implies that the valuation headwind in Europe over the coming 30 years could be at least as strong as in America. Note from the chart that the impact of Japan’s seismic population shift has evidently been in effect for some time and is by far the greatest of all.

But before we run off and sell all our shares in fear of the coming multiple compression we should consider a number of additional factors.

First, this is the most dire of the “life cycle model” projections for valuation. A similar study of the “M/Y” ratio3 (plotting the size of the middle aged group relative to the younger aged group) suggests a less dramatic outcome, with P/E multiples projected to be broadly flat from 2015 onwards. Second, as we have said, the prospects for stock market investors are determined both by valuation and by earnings power. There is no reason why an ageing population in a particular geography should necessitate lower corporate earnings power if the corporate sector can access growth elsewhere. One should remember that these historic relationships were produced when America & the West were the primary sources of incremental demand. This is no longer the case and in a world of multinational corporations and cross border investment flows it is global forces that matter most.

Finally, government policy is a key component in the outcome. Decisions on the retirement age and on the generosity of the provisions for retirement and healthcare will affect the labour supply and the availability of savings for investment purposes – potentially increasing valuations (and growth) if the right choices are made.

In conclusion, history strongly suggests that the World will benefit from the growth in aggregate population that is expected over the coming decades, as supply will respond more than adequately to demand. The Emerging economies will be able to increase both their populations and their standards of living alongside, rather than at the expense of the developed world. For some time to come our principle opportunity will lie both in identifying investments that enable this to happen and those that benefit from it. Although there will be a valuation headwind in the maturing developed economies for the foreseeable future, this should not overwhelm the positive force of earnings growth and may also be mitigated by sensible government policy.

How to invest if we are wrong? The Malthusian so called “positive checks to population” of hunger, disease and war would become the forces to wrestle with. Very few areas would prosper, but Agriculture, Healthcare, Defence and Gold would stand the best chance of preserving real wealth.

There will be a valuation headwind in the maturing developed economies for the foreseeable future, this should not overwhelm the positive force of earnings growth and may also be mitigated by sensible government policy.



After five years of doom and gloom, better days may at last lie ahead for UK banks, although a number of obstacles clearly remain. Perhaps reassuringly, this is not a consensus view and a number of market participants remain underweight in the sector, with the steep losses witnessed during the peak of the credit-crunch a not so distant memory.

The UK banks which required public investment, Lloyds and RBS, have made significant progress over the last few years to stabilise their balance sheets. Impairment levels on UK assets are also in decline, which should more than compensate for falling income levels, as these banks continue to de-leverage their balance sheets. UK banks have also made significant progress in terms of improving their capital positions and are some way ahead of peers in Continental Europe on this front.

Banks globally are also benefiting from the significant provision of liquidity from central banks, which has generated high levels of cash within the financial system. Specific to the UK, the new ‘Funding for
Lending’ scheme, by which banks can borrow from the Bank of England (BOE) at below market rates for specified lending, also seems to have provided a boost to the sector, with Credit Default Swap spreads and wholesale funding costs declining significantly in recent months. Recently, the Financial Conduct Authority (FCA) has relaxed liquidity rules for UK banks (on a temporary basis), which it is hoped may further encourage lending to UK consumers and corporates.

By nature, the banking sector is heavily influenced by the macroeconomic environment, both in the UK and globally. Perhaps the key development for the global economy in recent months has been a crucial step taken by the European Central Bank (ECB), which has now pledged unlimited resources towards supporting the sovereign bond markets of troubled Eurozone nations. Since this announcement, bank shares have soared, given that the probability of a Euro break-up has now diminished. It is hoped that a recovery in the Eurozone is now possible in the foreseeable future, which would be particularly positive for the UK, given that the Euro-Area is its largest trading partner.

Recently, the Financial Conduct Authority has also relaxed capital and liquidity rules for UK banks, which it is hoped may further encourage lending to UK consumers and corporates.

The outlook for the global economy will, as ever, also remain dependent on developments in the US and China. With regards to the US, there have been some very positive signs that the labour and housing markets are gaining momentum, despite fears of the potential ‘Fiscal Cliff’ this year. Consensus is that the ‘Fiscal Cliff’ will be avoided, although any failure of Democrats and Republicans to form an agreement would almost certainly de-rail the US economic recovery, with inevitable repercussions worldwide.

Meanwhile in China, it is hoped that after a recent slowdown the economy is now well positioned to accelerate in 2013 – there is a strong possibility that the new leadership regime will be eager to generate popularity in the early days, with a further loosening of fiscal and monetary policy potentially on the cards.

Overall as we enter 2013, provided the US avoids the ‘Fiscal Cliff’, the global macroeconomic outlook appears more promising and this can only be good news for banks, given the prospect of higher confidence, capital investment and improving asset quality.

However, despite some clearly positive developments in recent months, UK banks still face a number of challenges in the near-term. Although the macroeconomic environment looks set to improve, growth levels are still likely to be some way below what would be expected at this stage of the global economic recovery. The risk of a deterioration in conditions in the Eurozone also remains, despite the ECB recently removing some of the worst-case scenario ‘tail risks’. Banks also have a long way to go towards rebuilding confidence and trust. Recent issues regarding money-laundering, PPI, LIBOR and the mis-selling of interest rate swaps, have all taken their toll and banks are now paying the price through material penalty payments, which look likely to weigh on earnings for some time.

The future regulatory environment for banks is another area of uncertainty and perhaps the most threatening headwind facing the sector as we enter 2013. To put this issue into perspective, it has been estimated that the financial industry in the EU will spend around €35bn over the next three years in order to ensure compliance with various regulatory requirements. Under Basel III rules, minimum capital requirements will need to be met by 2019, while in the UK specifically the Independent Commission on Banking (ICB) has also recommended the ring-fencing of retail and investment banking activities.

Particularly in the UK, the uncertainty surrounding future regulation is a real concern for investors; this is perhaps one key reason why some of our banks trade on similar valuations to those in the Eurozone, who are operating in a much more uncertain economic environment. The Financial Policy Committee (FPC), which takes over from the FCA this year, has recently advocated that banks may be required to hold specific absolute levels of capital. This approach deviates from Basel III, which simply specifies targets for capital ratios and deems that current capital levels may not be adequate. This has raised the possibility that further rights issues could be around the corner, although we would view this as a last resort and that there would be a number of alternative options for banks to raise capital. Nevertheless, the potential for rule changes and a lack of clarity on regulation is likely to remain an issue for banks and their investors in the near term.

It is hoped that the legacy issues from the ‘bad old days’ of banking will soon be resolved and that the industry can finally move on and rebuild its reputation.

The FCA will be carrying out a review of the major UK banks, with a report due in March, which will hopefully conclude how much extra capital, if any, banks may need.

Overall, we remain cautiously optimistic that 2013 will be a positive year for UK banks. It is hoped that the legacy issues from the ‘bad old days’ of banking will soon be resolved and that the industry can finally move on and rebuild its reputation. It is crucial however that the regulatory requirements for UK banks become more transparent and that this becomes apparent sooner rather than later – indeed, it is hoped that once this is achieved, the banking sector will have the confidence to lend (if the demand is there) and provide the fuel for a UK economic recovery in 2013.

If you type ‘cloud computing’ into Google Trends, you’ll discover that web searches for the term in Google peaked in early 2011 and are now (at the time of writing) running at around 60% of that level. That might suggest it’s an old story – and indeed aspects of cloud computing have been around for many years – but in terms of its commercial impact it is as yet relatively embryonic.

That burst of enthusiasm for internet searches may be linked to the so-called ‘hype-cycle’ of expectations that is often observed with new technologies. This cycle moves through five phases, starting with the ‘technology trigger’ when the possibilities of the technology start to become understood and expectations build. It then moves towards the ‘peak of inflated expectations’ when all sorts of claims about how it is going to change the world start to run wild. This is followed (inevitably) by the ‘trough of disillusionment’ as people realise those claims were overdone and doubts set in over whether it will ever get off the ground. This invariably exaggerated phase then gives way to the ‘slope of enlightenment’ as a more realistic appraisal of its potential takes hold, before moving towards the final ‘plateau of productivity’ phase. The Google Trends data may indicate that cloud computing has moved past the peak of inflated expectations towards the latter stages of the cycle, although different aspects of it will be at different stages. This is illustrated in the following chart:

If so, the commercial importance may be about to become much more significant. Estimates vary – not helped by differing definitions – but some surveys suggest the market could grow to approaching $200bn per year (some of which will displace spending on ‘conventional’ computing) by 2020. This is illustrated in the chart above.

So, what is cloud computing, and why is it important?

The information technology business is more prone than most to jargon and it is easy to get bogged down in the argot. That isn’t helped by the fact that the boundaries of cloud computing – like those of the real things – are ill-defined, but there are some general characteristics that can be reasonably easily explained.

In essence, cloud computing entails the physical separation of computing resources (hardware and/or software) from the user, with the two sides connected via a network (e.g. the internet). So, instead of everybody in an organisation having a high-specification personal computer on the desk, with loads of memory and a suite of software programs installed, the desktop computer can be stripped right down to little more than a dummy terminal. The software and computing power is stored in a separate, central repository and can be accessed by users as and when required, via an internet browser. Typically these resources will be hosted remotely and provided by a third party, which has important implications for the economics of cloud computing, as we shall discuss later. The use of cloud computing has been likened to an electricity grid because of the ability to access unlimited resource on-demand, paid for on the basis of how much is used (as opposed to everybody having their own power station, running continuously whether needed or not).

Within this framework, the range of resources provided can vary widely, allowing for different depths of cloud, so to speak. Here, we limit our discussion to a couple of the simpler manifestations. Probably the simplest level, and one with which many consumers are already familiar, is web-based email services such as Google’s gmail or Microsoft’s hotmail, in which messages are stored remotely and managed by the provider’s software and infrastructure, which are accessed via a browser.
The great advantage of this to the consumer is that the service can be accessed from any device, be it desktop, laptop or mobile. Indeed, increasing mobility is one of the key drivers of demand for cloud computing, while ever improving network connectivity is a major enabler.

A similar principle applies with Apple’s iCloud, which stores music centrally and allows it to be played on any one of a number of devices, and to Amazon’s Kindle for reading, but these services still require the relevant software to be installed on each machine that is used to access the content. However, a further feature of cloud computing is the ability to access remotely-hosted software via the web – known as Software as a Service (SaaS). This, one of the more advanced facets of cloud computing, has several advantages for corporate users, including; (i) it allows them to use only what they need, as opposed to requiring multiple installations of software for which some users have only an occasional need; (ii) payment can be made only for what is used, on a pay-as-you-go basis, rather than through large, upfront licence fees; (iii) it is highly flexible, particularly in the context of increased mobility, since access isn’t limited to devices on which software is installed; and (iv) it is easy to manage, for example eliminating the need for installing software updates.

The implications of the changed pricing model under SaaS are significant to providers as well as users of software. On the one hand they will increasingly have to forego sizeable, upfront licence fees (a major driver of their appealing cash flow characteristics). On the other, lower initial costs to customers might encourage wider usage, with more regular cash flows and the opportunity to achieve greater lifetime revenues.

For corporate customers it is not just the potential to change the pricing model for software that has attractions. Many of them have a need for computing power that varies widely, either seasonally or through the day. This requires them to invest in and maintain a level of physical resource that is sufficient to meet their peak requirement but which has surplus capacity for much of the time. One advantage of cloud computing is that, as with software, this infrastructure can be accessed – and paid for – only when, and to the extent, needed. Clearly, if infrastructure was built to support only one user the issue of excess capacity would be simply displaced from the user to the provider. Therein lies one of the key features of cloud computing – the ability to share resources. Consider a simple example: two similar businesses, operating only during normal business hours but one located in the UK and one in New Zealand such that there is no overlap in the working day. Even if each uses its computer capacity to its fullest extent during opening hours, that capacity will be lying idle for around half the time. However, if they used shared resources, both businesses could be served by the equivalent of half their combined resources. Now imagine such an arrangement writ large across multiple users. This model, known as multi-tenancy, is the key to the business for cloud providers, for whom scale is all-important.

If it all sounds too good to be true, it is not without problems. There are a number of reasons why, despite the apparent economic benefits, some companies may be reluctant to adopt cloud computing models. According to industry surveys, by far the most common concern, perhaps unsurprisingly, is security and confidentiality. The idea of entrusting data – particularly things like financial information or medical records – to a third party whose servers are also being used by other, unknown, entities (including potential competitors) understandably engenders caution but in fact large, well resourced, specialist providers of cloud facilities are just as, if not more, likely to have effective security arrangements in place as a small business. The use of a cloud can also provide an additional, or alternative, disaster recovery policy. One way of addressing security concerns, most applicable to larger companies, is to have their own dedicated, ‘private’ cloud. However, this approach is likely to yield fewer cost savings than using a ‘public’ cloud where resources are shared with other users and which could save perhaps 50% of the cost of an in-house system.

Unsurprisingly, given the potential rewards, many companies are rushing to embrace the new technology. Many of these will be unknown to most investors but some familiar names such as Microsoft, Oracle and Google are also actively engaged in the provision of clouds. So too is Amazon, which identified it as an opportunity to leverage its substantial computing resources which are often running at well below capacity. Software vendors who are reconfiguring their businesses to operate via the cloud include Sage. Purveyors of ‘traditional’ IT solutions may suffer as a result of the disruptive influence of cloud computing but buyers of IT and, ultimately, consumers should see a silver lining.

Purveyors of ‘traditional’ IT solutions may suffer as a result of the disruptive influence of cloud computing but buyers of IT and, ultimately, consumers, should see a silver lining

In the old days it was easy. Equities were traditionally purchased for capital growth and bonds for relative stability and income. For years, a 60/40 equity/bond mix was considered optimal for a balanced asset allocation. The upside of equity growth was captured in portfolios but volatility was reduced and income boosted through the bond component. In fact, balanced portfolios of the past 30 years have benefited from the reduction in inflation and interest rates, and over the past couple of years quantitative easing, that have led to government bond yields in the major Western economies falling from near 20% to between 1% and 2%.

However, the past 30 years have also experienced the emergence of advanced credit markets and a huge expansion of corporate bonds (i.e. debt issued by companies). Credit markets can be broadly sliced into two: investment grade and high yield (which is also known as sub-investment grade or junk bonds). The credit rating agencies determine the grouping for the two categories of corporate debt. Using Standard & Poors terminology investment grade bonds are rated between AAA and BBB- (or equivalent) and the high yield bonds are rated below BBB-. In general, the lower the credit rating the greater the chance of default. This article will put forward the argument that high yield bonds perform more like equities than government bonds and their core attributes provide strong arguments for their inclusion in modern balanced portfolios.

In our opinion, the many reasons to consider high yield bonds as part of a balanced portfolio include:

High yield bonds perform more like equities than government bonds and their core attributes provide strong arguments for their inclusion in modern balanced portfolios.

Valuations appear attractive relative to government bonds and cash

The latest guidance from the Chairman of the Board of Governors of the US Federal Reserve, Ben Bernanke, is that the Fed will continue with its programme of quantitative easing until US unemployment falls to more normal levels and will retain interest rates at very low levels through to at least 2015. As a result, higher yielding asset classes are still very much in demand. In credit spread terms (the yield difference between high yield and government bonds), the former continue to appear very attractive e.g. the US high yield market, at a yield to maturity of 6.6%, provides an incremental return of nearly 5% over the 10 year Treasury yield of 1.6%. However, in absolute terms, the yield of 6.6% is back to the lowest levels seen since the end of 2004 and early-to-mid 2011. For many high yield bond investors, the market is thus currently looking fairly valued. Even if yields do not fall from current levels, the market could still provide returns in the form of income at c.6-7% p.a., very significantly better than government bonds.


High yield bonds provide attractive risk-adjusted returns and low correlations with government bonds.


Experiences from the financial crisis and global recession of the past few years show that high yield bonds can provide attractive risk-adjusted returns in uncertain economic and market environments. For example, in 2008, when ‘risk’ assets were sold off sharply and high yield bond fund managers were forced sellers of their better quality debt instruments (the lower quality bonds were very difficult to sell), the US high yield bond market produced a negative total return of 26.4%. However, in the same period, the US equity market saw a negative total return of 37%. In the market rebound of 2009, the US high yield market achieved a total return of 57.5%, much greater than the 26.5% from the US equity market.

In addition, the table above shows the low level of correlation between US Treasuries and US high yield bonds. As you can see over the past 25 years the data derived from Bloomberg shows that the US high yield market has a closer correlation with US equities than US Treasuries.

High yield default rates are historically low

From a fundamental perspective, high yield corporate default rates continue to be low. Strong corporate profitability is creating favourable interest coverage ratios, and balance sheets have ample liquidity with record cash balances and minimal maturities over the next couple of years. The Moody’s trailing 12 month default rate for the US high yield market is 3.5%. This compares favourably against a long-term historical average of c.4.5%.

High yield bond managers can provide different risk and reward characteristics to investors

High yield bond managers have two main variables to performance: credit rating focus e.g. better-rated BB-rated bonds vs lower-rated CCC-rated bonds and geographical exposure (the main two markets are the US – 80% of the market – and Europe). With a market showing fair value characteristics, higher-return investors with a greater tolerance of risk should seek exposure to lower credit-rated European bonds; more risk-averse investors should seek higher-rated bonds centred on the US market.

Over time, investors are coming to view the high yield bond market as a good alternative and even a complement to equities. Characteristics of the high yield market include:

  • The majority of the return is in the form of income. Unlike a number of equity markets such as the UK, where certain sectors such as oil and utilities are major income providers, there is a wide base of companies and sectors providing income.
  • Lower volatility compared with equities (given the higher claims in the capital structure).
  • Exposure to non-financial companies (unlike the investment grade market which is traditionally dominated by bank bonds).
  • Exposure to strong balance sheets, particularly as the market is mainly focused in the US (which is experiencing an economic rebound).
  • A higher correlation with ‘risk’ assets than government bonds.

In conclusion, the high yield market has space for yields to fall further and prices to rise in this low interest rate environment. However, clipping coupons at a rate of 6-7% annually may be sufficient for many investors with income requirements and lower volatility expectations.

Note: When discussing characteristics and performance for the high yield market, figures refer to the Bank of America Merrill Lynch US High Yield Master Index.

Experiences from the financial crisis and global recession of the past few years show that high yield bonds can provide attractive risk-adjusted returns in uncertain economic and market environments.


Ever since Man realised that the black viscous liquid that emerged from tar pits was a useful fuel, the oil & gas industry has been mired in controversy. The past 101 years has lurched from the breakup of Rockefeller’s Standard Oil to BP’s disaster in the Gulf of Mexico, via the Exxon Valdez, the Iranian revolution and the questionable size of Shell’s reserves. The most common economic controversies now surrounding the industry currently are ‘Peak Oil’ and the impact of shale-borne oil & gas.

Rising demand for hydrocarbons has been taken as a given for decades but there has been some change in the structure of the market. Since peaking in 2005 developed world demand has fallen and is forecast to have dropped by 10% by the middle of the decade. At first the drop was thought to be cyclical but now trends, particularly in the USA, suggest that there may be long-term changes in play. Increased regulation of fuel economy, the greying of America and the growing urbanisation of 18-35 year olds are all reducing petrol usage. President Obama has tightened the standards which regulate the fuel economy of the average car produced by each manufacturer selling cars in the US. Not only has the miles per gallon restriction risen but for the first time 4x4s and People Carriers have been included in the corporate average. Changing demographics have reduced the miles driven as retiring workers reduce their commuting miles and Generation X increasingly prefer to live and work in an urban environment rejecting their parents’ suburban lifestyle. As a consequence US petroleum demand dropped 16% between 2006 and 2011.


The most common economic controversies now surrounding the industry currently are ‘Peak Oil’ and the impact of shale-borne oil & gas.

However, this is only half the story. In the 20 years from 1996 to 2016 non-OECD countries (effectively emerging economies) will have doubled their use of oil from 25m to 50m barrels per day, in the process surpassing the developed world in the current year. Chinese demand is forecast to treble over a similar period.

The story is similar in gas where more capacity is coming on-stream but demand is forecast to outgrow supply, particularly as China attempts to raise its usage of gas as a cleaner fuel replacing some of the inefficient coal powered power stations. Only 4% of China’s energy is currently generated from gas compared to approximately 40% for most developed nations. The problem is the lack of infrastructure but given the rate at which the Chinese introduced Bullet trains then, if there is the will to do it, the pipelines, Liquefied Natural Gas (LNG) terminals and gathering systems are likely to get built. BG Group, the world’s largest gas company, estimates that Chinese gas demand will grow by 11.2% per annum this decade compared to 0.1% per annum for Europe.

Supply is just as difficult to forecast; the International Energy Agency’s (IEA) forecasts were regularly revised downwards as declines in production from regions such as the North Sea were occurring more quickly than expected. However, in the last two or three years this has reversed with the IEA’s forecasts being too conservative. It would be easy to explain this by referring to new frontier exploration, for example large oil finds offshore Brazil and Ghana. However, this would tend to ignore the bigger picture. Following the large discoveries during the Fifties and Sixties in places like Libya,
Venezuela and the North Sea, increased nationalisation of hydrocarbon assets and the two oil crises of the Seventies, the oil price remained depressed for two decades and oil company capital expenditures barely grew faster than that needed to maintain facilities. Consequently, in the Eighties and Nineties, most major oil companies were overproducing by comparison with their oil reserves. Since the turn of the century oil company exploration spending has grown by 15% per annum. Given the lead time in identifying prospects, completing geological surveys and drilling wells, the 10 year gap between accelerated spending and positive surprises when compared to the IEA forecasts, is not surprising. Continued drilling success in Brazil, Ghana, Kenya and re-examination of the old regions with new techniques is potentially changing the view of Peak Oil, which brings us to the subject of shale oil and gas.

In view of the poor short term economics of shale gas, emphasis has switched to shale oil and drilling for this has started in earnest. The broad impact of success could be startling.

Shale is a rock formed from compacted mud and often contains fossils, bitumen (as in bitumen coal) and hydrocarbon deposits; it is the latter which interests the oil and gas industry. It has long been known that certain types of rock contain tightly bound hydrocarbons. A typical example is coal, which provided the UK with gas until the discovery of North Sea gas in the 1960s and will once again be a source, particularly being exported in liquefied form from Australia, over the coming decade. However, shale is the big story and involves the coming together of two techniques that have been around for some time. Horizontal drilling involves a flexible drill stem that once it reaches the necessary depth can be sidetracked and then steered through a stratum of rock. The technique has been in use since the 1980s. Hydraulic Fracturing has been used by the oil industry since 1947 and involves pumping liquid into the drill hole at high pressure to fracture rock to release gas and, increasingly, light crude oil. Each well reaches its peak within the first two years and then declines to a low level and then produces at that level for some years. To exploit the resource involves many wells, but these are relatively cheap and can be drilled and producing in three months.

So far the US is the only country to exploit this resource successfully, so much so that there is now a natural gas glut in the US and transport companies like FedEx and UPS are increasingly converting parts of their North American truck fleet to use it as a fuel. The net effect has been to drive the US gas price down, at one point reaching $2 per thousand cubic foot of gas (MCF) which was below the cost of production.

In view of the poor short term economics of shale gas, emphasis has switched to shale oil and drilling for this has started in earnest. The broad impact of success could be startling. US oil production is estimated to rise by four to eight million barrels per day (bbls/day) before the end of the decade, the higher figure being the current volume of US imports of crude oil and around 10% of world production. The effect of this would be to wipe out the US trade deficit and put downward pressure on oil prices.

The natural gas glut has already begun to impact US industry, making it more competitive. For instance, chemical companies have begun to reopen and are planning to add to capacity in the US to take advantage of the cheap and abundant gas as a raw material. The most optimistic forecasters suggest that there will be a renaissance in US industry and that the US dollar will strengthen further as outside (i.e. Chinese and Japanese) funding becomes unnecessary. The shale story is not just a US phenomenon. In the UK, drilling near Blackpool is suspected of causing a minor earthquake. Despite projections of large reserves in the country’s shale deposits, success in Poland has been elusive as wells have, like a roman candle, flared and died. Argentina has already managed one constructive well and is estimated to have the most potential outside of the US, and China is a huge unknown but many of the multinationals are already investigating the opportunity. The problem for many of these prospects is that they suffer from lack of infrastructure, expertise and pumping equipment that exists in the US. Development of non-US reserves may take longer than some commentators expect but, if successful, it could significantly move the balance of power in the oil industry away from the Middle East and potentially impact the geopolitical landscape.

It is difficult at this point to draw many firm conclusions except that there is a decent probability that most consensus forecasters will be wrong and that there are reasons to be optimistic on energy supply. Peak oil may not be behind us as feared and US Shale could lead to changes in the underlying economy and make more non-North American resources available to the faster growing economies. Although risks such as an Israel/Iran conflict could still throw a spanner in the works on a temporary basis, the new supply could reduce inflation in the fuel supply chain for some years and enable faster global growth.

The defence sector has been relatively unloved since the peak of the global financial crisis at the end of 2008. Investors first switched into more cyclical areas that would benefit from the significant monetary stimulus of quantitative easing (along with fiscal stimulus), and latterly became concerned about the impact on the defence companies from government budget cuts in an era of austerity. While the latter concern is a very real one, there are reasons to be more sanguine about the outlook for the defence companies and to look forward to a time when they are once again viewed as attractive investment candidates.

The global defence sector – represented by the 10 largest publically traded companies which derive a majority of their sales from defence (Lockheed Martin, BAE Systems, Northrop Grumman, General Dynamics, Raytheon, Finmeccanica, L-3, Thales, SAIC and Oshkosh Truck) – currently trades on a fairly depressed valuation relative to history. Its Price to Earnings Ratio based on expectations of the next 12 months’ earnings stands at 9.3x, which is a significant discount to the 15 year average of 13.8x and to the 14-16x which it typically traded on for the decade before the global financial crisis. Over slightly more than four years from the middle of August 2008 (when defence stocks peaked in terms of share price performance), the top 10 defence stocks have fallen in dollar terms by an average of 9.2% on a total return basis (i.e. including dividends), compared with the MSCI World Index which has risen by 8.8%.

The US is by far the most important defence market in the world, with its 2011 military budget of $711bn representing 41% of the world’s total.

The recent underperformance by the defence sector has been driven primarily by concerns about the outlook for defence spending in the developed world, where ballooning budget deficits have meant increased scrutiny of all major areas of government expenditure. Seven of the top 10 nations in terms of military spending saw their defence budgets fall in real terms in 2011 as they attempted to tackle their fiscal deficits. In the UK the Coalition Government published the Strategic Defence and Security Review in October 2010 which sought to cut the defence budget by 8% over four years, in part by axing 17,000 armed forces personnel and 25,000 civilian defence staff.

The US is by far the most important defence market in the world, with its 2011 military budget of $711bn representing 41% of the world’s total. Following President Obama’s re-election, and the continued split control of Congress, the parties must agree on budget control measures in order to raise the debt ceiling and thereby avoid what has been termed the ‘fiscal cliff’. However, the Republicans remain opposed to tax increases for the wealthy, which the Democrats favour, and prefer to see cuts to entitlements within public spending.

The world remains an insecure place, particularly so at a time of increasing environmental concerns and of slower economic growth, which can cause countries to compete more aggressively for scarce resources.

Failure to agree $1.2 trillion of deficit reduction measures will mean, under the Budget Control Act of 2011, the triggering of across the board cuts, known as ‘sequestration’, on 1st January 2013. At the time of writing we do not know the outcome, but given protections for areas like Social Security and Medicaid, this sequestration would disproportionately impact the defence budget, which has already been cut by $487bn over 10 years. Sequestration would most likely mean a sharp further reduction in the defence budget (by 9% in 2013) with the budget rising only by the level of inflation for the next eight years to 2021. Senator John McCain has described this budgetary reduction as representing ‘a threat to the national security interests of the United States’.

However, the Republicans are incentivised to reach a compromise that would avoid the damage of sequestration to the defence budget. Some commentators expect a scenario of a ‘bungee jump off the fiscal cliff’ whereby the sequestration deadline passes and this shocks the political establishment into finally reaching an agreement to cut the deficit in a more measured way that would limit the cuts to defence spending. It should also be remembered that defence spending would have reduced in any case, given the pending US troop withdrawal from Afghanistan by 2014. The political class will face significant pressure from defence company lobbyists and unions not to allow excessive hits to defence budgets, and will be very sensitive to the potential for job losses.

While US defence spending will be circumscribed in this situation, and items such as large land platforms and training may face particular pressure, other areas will continue to be prioritised and therefore see rising real budgets. Defence companies with favourable exposure to these areas should see decent business prospects. These growth opportunities include electronic warfare, cybersecurity and unmanned aerial vehicles (UAVs or drones), all of which involve a high degree of technical complexity, and which enable the extension of military capability beyond the scope of ‘boots on the ground’.

The world remains an insecure place, particularly so at a time of increasing environmental concerns and of slower economic growth, which can cause countries to compete more aggressively for scarce resources. There are simmering tensions in the Middle East, notably between Iran and Israel, and the destabilisation of various regimes, currently Assad’s Syria. This creates significant demand for military equipment in countries like Saudi Arabia, a key ally for the US and the UK. While Western defence companies are prohibited from supplying China with equipment, there is growing demand from China’s neighbours, notably India, Australia and the South-East Asian nations, who are wary of its growing territorial ambitions and its heavy military spending, which has grown by 170% in real terms since 2002.

Meanwhile a recent draft report by the US-China Economic and Security Review Commission identified China as the biggest cybersecurity threat to the US, saying that ‘Chinese penetrations of defense systems threaten the US military’s readiness and ability to operate’. Russia is also increasing its military spending, with its draft budget suggesting a rise of 53% in real terms up to 2014, which will limit the ability of European nations to curb their defence budgets.

So, even though US and UK defence budgets are likely to see much lower growth in the future than they have in the recent past, they remain large in absolute terms and contain potentially interesting growth niches. As emerging market nations grow to be a larger share of world GDP, they will also increase their share of global defence spending, and the US’s relative dominance will fall somewhat, creating some lucrative new markets for Western defence companies to operate in. Geopolitical tensions will add to the need to maintain military spending, while the ever-present threat of terrorism will require innovative homeland security solutions.

Aside from the growth opportunities, the defence sector offers specific attractions currently. The sector has de-rated relative to its historic averages, as we have seen, and now represents potentially good value against the market, in particular against other defensive sectors such as food and tobacco, which are trading at very high premia to the market relative to history. Companies have been aware of the fiscal cliff for quite a while, and have been proactive in cutting costs, and in particular fixed costs, an example being BAE Systems which reduced its headcount by 22,000 or around 20% between 2009 and 2011. This is part of the reason why the defence sector has performed quite well during 2012, as the market has taken the view that budget cuts may not be as swingeing as expected, in which case the cost cutting could potentially lead to margin upside and positive earnings surprise. Margins should also be protected by the fact that the sector has seen significant consolidation over the past two decades, and hence in a number of areas is less competitive than it was, even where growth is lacklustre.

Defence companies tend to be very cash generative with solid balance sheets, enabling them to pay secure and growing dividends, and in some cases to return cash to shareholders through special dividends or share buyback programmes. The four largest defence companies (Lockheed
Martin, Northrop Grumman, General Dynamics and Raytheon) are forecast to pay an average dividend yield of 3.8%, which compares favourably with the US market average of 2.4%.

Margins should also be protected by the fact that the sector has seen significant consolidation over the past two decades, and hence in a number of areas is less competitive than it was, even where growth is lacklustre.

Thus while there remains uncertainty in the short term, defence stocks appear reasonably well underpinned by valuation and dividends. In the medium term, growth prospects are promising for Western defence companies, given their technology leadership and high barriers to entry, often built up over many decades, which should enable them to make increasing inroads into emerging markets. Finally it is also worth remembering that the defence and aerospace stocks are well placed to capitalise upon any renewed interest in space exploration.


China (and specifically Inner Mongolia) has the lion’s share of the naturally occurring deposits.

The Lanthanides were once familiar only to chemistry students and general-knowledge crossword buffs. Through the more colloquial term ‘Rare Earths’, they have entered the mainstream lexicon over the last few years, both as a small but essential component of our modern day electronics but more dramatically as a bargaining tool which has seen the US, Europe and Japan stockpiling resources while lodging complaints with the World Trade Organisation accusing the Chinese of unfair trade practices.

This article looks at what this curious group of elements is, what we use them for, why the Chinese have such a stranglehold on supplies, and ultimately why the economics of these esoteric elements might keep the Western world in iPhones for years to come.

First the chemistry primer: Rare Earth Elements (REE) is the collective name for a group of 17 elements, namely Scandium, Yttrium and the 15 Lanthanides – Lanthanum through to Lutetium. They are all solid metals at room temperature. ‘Rare’ is something of a misnomer as they are actually relatively abundant in the earth’s crust; indeed at 68 parts per million (ppm) Cerium is more abundant than Copper. To put this in layman’s terms, if all the material in the earth’s crust were reduced to the size of an Olympic swimming pool (3,750,000 litres of water) – the most abundant REE, Cerium, would be about 255 litres (half a bath full), the scarcest, Thulium, would be two bottles of wine and, as a reference, Gold would be four sugar lumps.

The term ‘Rare’ better reflects their occurrence in significant, economically workable deposits which are very few and far between. According to the US Geological Survey, China has reserves of 27m tonnes (31%) followed by the Commonwealth of Independent States (i.e. most of the former Soviet block, ex. the Baltic States) with 19m tonnes (22%) and then the US (13m tonnes or 15%).


These Rare Earth metals are primarily used in relatively small quantities in advanced electrical and engineering products, for example catalysts, high performance batteries, and even magnets in the wind turbines seen in the UK (a 3MW Siemens turbine contains 600kg of Neodymium). Manufacturing the latest iPhone from Apple is thought to involve no fewer than 9 of the 17 Rare Earth metals, in areas from the circuitry to the speakers and the materials used to polish the glass screens.

Whilst China (and specifically Inner Mongolia) has the lion’s share of the naturally occurring deposits, it has also historically had very lax environmental controls compared to, say, the US, which meant that the metals could be extracted at relatively little cost and certainly far below the cost of production in the developed world. As a consequence, from the mid 1990s onward Chinese production grew rapidly whilst the rest of the world declined, such that China now directly accounts for
c.90% of the world’s supply and through supply contracts with overseas producers has cornered another c.7% of the market.

Until 2008 this was not much of a problem; global demand had grown by c.8% p.a. from 2005 to 2008, broadly tracking supply, and up until 2008 Chinese export quotas had been running at 50,000 to 70,000 tonnes p.a., more than covering ex-China demand. However, from 2008 onwards, China started to dramatically reduce the quota levels citing increasing environmental standards which reduced production levels and left less to export. This led to a sharp spike in the prices of the metals and complaints from western consumers, particularly Japan, doing nothing to help Sino-Japanese relations which remain diplomatically frosty. (Whilst it is easy to be cynical, the environmental angle is believable given the particularly unpleasant by-products of the Rare Earth extraction process – including radioactive and toxic materials – which leach from waste-water lakes into agricultural areas and were described by one Daily Mail reporter as “apocalyptic”).

It also prompted a flurry of speculative investment, both in the shares of the few companies at the forefront of Rare Earth production and to a lesser extent directly in the metals themselves.


Whatever the reason for dramatically tightening export quotas, it appears that the Chinese may have killed the golden goose as far as Rare Earth pricing is concerned. If the aim was to exert political influence then it looks to have failed, with consumers of Rare Earths certainly suffering a period of discomfort but seemingly little more. Thanks to rampant smuggling out of China, the economic slowdown reducing demand and the strategic importance of Rare Earths to areas such as Defence and electronic warfare (meaning that ex-China production would be advanced whatever the cost), prices have fallen and more politically-friendly sources of supply have come on stream.

Several exchange traded funds (funds which trade like a normal company share but give exposure to the underlying metal) which have been set up in the last 24 months to try and capitalise on the price squeeze have potentially found themselves arriving too late to the party, with plummeting values and waning demand.

Export quotas continued to fall up until 2012, when for the first time there was a modest uplift to just under 31,000 tonnes. With little growth seen in the near-term as a combination of sluggish demand and increasing production elsewhere (India and a resumption of production in the US to name but two) means that aside from stockpiling, the global market appears suitably supplied. It would also appear that China is being good to its word of seeking to raise environmental standards, with some former major producers not being awarded any quotas until environmental standards are improved.

Whatever the reason for dramatically tightening export quotas, it appears that the Chinese may have killed the golden goose as far as Rare Earth pricing is concerned.

In conclusion, demand for products containing Rare Earths will almost certainly increase, partly as and when the economic backdrop improves, but also thanks to changing Western energy consumption (think magnets in wind turbines and batteries in electric cars). However, the consumers of Rare Earths have had such an acute demonstration of how overly dependent the industry had become on a single source, that diversification of supply and in some cases substitution of Rare Earths for more conventional metals means such a broad upward price shock is unlikely to be repeated. This does not mean that the producers of these metals have necessarily become bad companies, nor that there is no upside potential in the price of the metals in the longer term, but expectations have been suitably rebased and both should now to be regarded as more conventional (if still speculative) investments rather than the next Coca-Cola.



John Haynes

Head of Research

John heads up a research team of 16 people all based in London, as well as researching individual UK equities himself. With his history of managing funds in the US, he also has input into US equity coverage. He is Chairman of the Global Investment Strategy Group and the Asset Allocation Committee and a member of the Stock Sector Committee.

Jim Wood-Smith

Chief Investment Strategist

Jim works with the business development team helping to build our presence in the professional marketplace, as well as sitting on the Global Investment Strategy Group and Asset Allocation Committee. He is responsible for Weekly Digest, our regular market commentary.


Guy Ellison

Senior Equity Analyst

Guy covers several sectors of the UK equity market and maintains the firm’s model portfolios. He is Chairman of the Stock Sector Committee, which recommends sector weightings and a core list of equities, and is a member of the Asset Allocation Committee.

Simon Lapthorne

Senior Equity Analyst

Simon covers the Technology, Media and Telecommunications sectors with a primary focus on UK companies. He also sits on the Stock Sector Committee.

Jim McCabe

Senior Equity Analyst

Jim researches and monitors shares across a number of UK sectors, with particular emphasis on a core list of stocks. He is a member of the Stock Sector Committee that decides sector weightings and maintains the core recommended list of shares. Jim is also responsible for developing and maintaining the core US share list.


Sanjiv Tumkur

Senior Equity Analyst

Sanjiv provides equity analysis and recommendations to the firm’s investment managers. He is also a member of the Stock Sector Committee, which determines the firm’s sector strategy and core stock list. In addition, Sanjiv is responsible for developing a research service covering Continental European equities.

Darren Ruane

Senior Bond Strategist

Darren provides overall commentary on global bond markets, including research on individual bonds.

In addition, he is responsible for selecting bond funds and managing the firm’s largest fixed interest mandates. Darren is a member of the company’s Asset Allocation, Global Investment Strategy and Collectives Committees.

Peter Tasou

Research Analyst

Peter is a member of the Research team and the Stock Sector Committee. His key area of focus is UK Financials. He is also responsible for writing various market and economic publications for clients and professional advisers.


If you would like any information on Investec Wealth & Investment’s service offering, please contact Mark Stevens on 020 7597 1234 (e-mail: mark.stevens@investecwin.co.uk).

Alternatively, please contact one of our offices.

This publication was produced in December 2012 for circulation in January 2013.

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