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‘We’re at the early stages of a credit crisis’ says Schroders’ Alan Brown

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Schroders warned of a bleak economic outlook for the UK in 2012 at its annual crystal ball breakfast meeting hosted by Alan Brown, Group CIO and Azad Zangana, European Economist in London this week.  

The overriding opinion of Schroders is that the UK will be in recession next year as the continuing deterioration of the eurozone takes grip. If the wheels fall off the eurozone it will present a “very serious risk” in Brown’s opinion, who stated: “We’re at the early stages of a credit crisis, yields are coming under pressure as money migrates to Germany. Right now the outlook ranges from terrible to absolutely awful.”

2011 has seen intense volatility and unnerving degrees of correlation across assets. Trading screens have literally been a sea of green one week, a sea of red the next making it particularly tough for stock pickers.

Brown said that whilst they’d been correct on macro themes last year they were “perhaps a bit too sanguine”. Indeed, up until the middle of June this year equities were doing pretty well. Now, depending on what markets you look at, they’re down around 20 per cent. Brown said that investors were being told they needed to be more dynamic with their asset allocations. If that message hasn’t sunk in this year, it likely never will.

Zangana said things were going to get worse next year and thinks we’re at the second stage of a credit crisis. “Banks are starting to distrust each other. We haven’t seen a real impact on the UK economy, that’s yet to come,” said Zangana rather ominously. Noting that roughly 50 per cent of the UK’s total exports go to the eurozone, he said he struggled to see “how the UK will avoid a serious recession if one starts in Europe”.

The two macro themes to consider in 2012, said Brown, were a double dip recession and the eurozone crisis. Many argue that the UK is already in recession and rather than it being a separate event, is merely a continuation of the ’08 global meltdown.

He said that the binary outcomes being faced are difficult to manage. So much depends on what Germany does. “We judge that the ECB must become the lender of last resort. I can’t imagine that over the next 12 months there won’t be a resolution. For better or worse, we’ll know our destiny next year,” said Brown.

If the ECB bazooka were deployed it would go a long towards reassuring the markets and easing pressure on the likes of Italy, a country far too big too fail and whose yields continue to hover around 7 per cent. Whether it fully resolves the eurozone crisis is unknown, but something needs to be done to stop investors ploughing money into US treasuries and German bunds.

The valuation gap between equities and bonds remains wide said Brown, noting that nobody buys a bond yielding 2 per cent (US 10-year treasuries currently yield 2.1 per cent) out of greed, rather it’s done out of fear. A 10-year treasury will yield 5.5 per cent on a nominal basis. This shows the extent of overvaluation in the market. It’s hardly a great solution for institutions facing long-term liability pressures.

Brown referred to the Marks & Spencer corporate bond yielding 5.5 per cent and argued that in his view it represented better value than UK government bonds at present.

He said the only solution to the eurozone crisis was to change the exchange rate between stronger northern EU countries and weaker southern EU countries, noting that the risk of Greece leaving is that it could lead to a domino effect. “Two institutions need to be unleashed to contain this issue in our opinion and these are Germany and the ECB,” said Brown.

One worrying economic indicator that Zangana referred to was that Manufacturing PMI had fallen over the last five months into negative territory: a sign that inventories are stockpiling as new orders slow down.

“Our baseline economic forecast for the UK in 2012 is -0.4 per cent, and for the eurozone it’s -1.8 per cent. We forecast global growth to slow down to 1.8 per cent in 2012 (compared to 3 per cent in 2011),” explained Zangana. It should be pointed out that Schroders’ forecast is the most bearish amongst UK forecaster. The consensus is that UK growth next year will be +1.1 per cent and +0.4 per cent in the eurozone.

Zangana said that unemployment could rise above 9 per cent by 2013 and that household prices are set to double dip next year, falling around 6 per cent. On the flip side, inflation is not expected to be a concern next year and will likely surprise on the downside. It is, however, forecast to rise again in 2013. “We expect the Bank of England to keep interest rates on hold until 2014,” added Zangana.

Amidst this gloomy backdrop, how are investors supposed to allocate to their portfolios? Brown said that Schroders’ is around 30 per cent invested in equities, with no exposure to Europe, with a focus on high dividend stocks.

“We’re also invested in corporate credit, have a hedged position in gold and hold quite a substantial cash position. We’re about as defensively positioned as we can be and won’t move until we see a clear outcome in the eurozone next year.”

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