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Broadgate: Weekly Briefing 7/10

7 October 2013U.S. – US President Barack Obama has warned that Wall Street should be concerned that a conservative faction of Republicans is willing to allow the country to default on its debt.

The US government has partially closed after Congress failed to agree a budget and will run out of cash on 17 October unless its debt ceiling is raised. The shutdown has left more than 700,000 employees on unpaid leave and closed national parks, tourist sites, government websites, office buildings, and more.

On Thursday, US stockmarkets fell and the dollar dropped to an eight month low over growing concerns of the economic effects of the stand-off over the US budget. The S&P 500 and Dow Jones indices both finished the day down 0.9%, while the Nasdaq fell by more than 1%.

Both the US Treasury and IMF managing director Christine Lagarde warned of dire effects if the US was unable to agree a deal to raise the US debt ceiling.

A report from the US Treasury warned that if an agreement on the debt ceiling is not reached before 17 October the US would be plunged into the biggest recession since the Great Depression.

The report said: “A default would be unprecedented and has the potential to be catastrophic. Credit markets could freeze, the value of the dollar could plummet, US interest rates could skyrocket, the negative spillovers could reverberate around the world, and there might be a financial crisis and recession that could echo the events of 2008 or worse.”

And Lagarde urged US politicians to find a way to break the deadlock: “In the midst of this fiscal challenge, the ongoing political uncertainty over the budget and the debt ceiling does not help. The government shutdown is bad enough, but failure to raise the debt ceiling would be far worse, and could very seriously damage not only the US economy, but the entire global economy.”

Japan – Japan’s Prime Minister Shinzo Abe said his government will raise the rate of sales tax to 8% from 1 April next year, from the current 5%.

Policymakers have argued that the hike is key to reducing Japan’s public debt – which now stands as around 230% of its gross domestic product. There have been concerns that such a move may hurt domestic demand.

However, analysts said recent data showing signs of a recovery in the economy had helped allay those fears. Legislation passed by Mr Abe’s predecessor last year had called for the rate to be raised.

The government needs to increase its revenue as it looks to fund rising welfare costs, driven by an ageing population, it is estimated that 40% of Japan’s population will be of retirement age by 2060.

Portugal – The Portuguese government forecast faster growth next year while keeping its deficit targets unchanged as it tries to exit its bailout program.

“There are early signs of a recovery in economic activity,” the International Monetary Fund said on Thursday in a joint statement with the European Commission and European Central Bank about the completion of the eighth and ninth reviews of the Portuguese aid plan.

Prime Minister Pedro Passos Coelho has to trim spending by approximately €3.3bn ($4.5bn) in 2014 after relying mainly on tax increases this year to meet targets set in the aid program from the European Union and IMF. Portugal is trying to regain full access to debt markets with the end of the €78bn rescue plan approaching in June 2014.

Commodities – Gold analysts are bullish for a third consecutive week on speculation that the first U.S. government shutdown in 17 years and a standoff over raising the country’s debt limit will spur demand for the metal as a haven.

Eighteen analysts surveyed by Bloomberg expect prices to rise next week, eight are bearish and four neutral. That’s the longest positive run since July. Bullion capped a 7.6% gain last quarter, the first in a year, as the U.S. Federal Reserve unexpectedly refrained from tapering its $85bn-per-month bond-purchase program.

Gold, heading for its first annual drop in 13 years after some investors lost faith in the metal as a store of value, rose as much as 3% during the three-week U.S. shutdown that began in December 1995. The Bloomberg U.S. Dollar Index neared a seven-month low on concern the stalemate may weaken economic growth and postpone the tapering of stimulus. Bullion rose 70% from December 2008 to June 2011 as the Fed pumped more than $2tn into the financial system.

Spotlight on: Investor Psychology during uncertain times

Investor psychology seems a bigger factor when shares are volatile, and certainly in the current choppy markets a renewed interest has been triggered in behavioural finance.

There have been good returns from equities following the financial crisis, but capturing those has not been easy.

The U.K’s Financial Conduct Authority is encouraging advisers to make use of behavioural finance. Both financial planning and regulation should be founded on an understanding of how consumers actually make decisions.

But, advisers need real-world evidence and applications. How can an understanding of psychology and investor behaviour deliver practical results?

Emotion and instinct

Applying behavioural finance is not a matter of trying to eliminate emotion. Instinct can aid decision-making – what matters is knowing when gut feeling lets us down.

The biggest investing errors are not informational or analytical, but psychological. It is little use to have a superior insight into value, if the position is not held long enough.

Over the past two years, some of the best performing shares have also been some of the most volatile.

Clients who are shaken-out of shares in market setbacks, will fail to capture the longer-term equity risk premium.

Healthy scepticism

One of the first issues advisers and clients should recognise is the need for healthy scepticism over experts and analysts.

Analysts are typically too optimistic, with forecasts for market returns each year being consistently too high. Over the past 25 years, forecasts for S&P 500 earnings have averaged 10%-12%, with the actual earnings outcome being growth of just 6%.

Indeed, over 25 years, only twice have forecasts underestimated actual earnings growth, with those exceptions coming in the earnings recovery following a recession. And, few research reports offer sell ratings. Fund managers, too, can have this optimism bias.

There is also clear evidence of the herd-like behaviour of analysts, clustering around consensus. This may offer career safety, but means company results can wrong-foot the market, even where there is extensive research coverage.

For example, in July this year, 30 analysts made forecasts for Apple’s iPhone sales in the previous quarter, reflecting the analysts’ channel checks and other research.

The actual outcome was a figure well outside the entire spread of all 30. Many not only look at their peers, attempting to stay within the pack, but are also guided by companies rather than applying an original view.

So, investors should not be influenced too much by these forecasts, but should put goal setting and portfolio structure at the root of their financial planning.

Analysts and experts can only be assessed if they make clear, verifiable forecasts. Recognition of counter-arguments, or signs that contradictory information has not been overlooked, helps credibility. And, while direct contact with companies, and anecdotes from those meetings, can impress, they do not necessarily produce better analysis.

Investor terms

Advisers like direct contact with fund managers, but should use these meetings to collect specific information. Recent research has highlighted the need to be alert for encouraging language and stories. Investors like terms such as ‘conviction’, ‘selective’, ‘quality’ and ‘fundamental’.

But, the words have an emotional appeal that is not always supported by real meaning. Research has also revealed the pattern of investment firms using meta-narratives, or overarching stories that help to carry them and their clients through difficult times.

Phrases like ‘we are value investors, and right now valuations are too rich’, should not be recognised as a story and questioned. Managers usually outperform their style benchmark when it is out of favour, and vice-versa. This lag in rising markets is less often questioned by clients, who are happy with absolute gains and focus less on stock selection.

There is ample scope to spin the results. It is human nature to favour stories, linking information together. But the chain stops us questioning each part of the narrative. Research has also been done on the impact of underperformance on fund managers.

At the outset of an appointment or investment, clients and trustees usually have an idealised impression of their appointed manager.

But under pressure, after a period of substantial underperformance, behaviour and style can change. This is not something that may be evident from investment reports.

Managing client anxiety through difficult times can be helped by setting structures and rules in advance. Portfolios with a 60/40 mix of equities and bonds have outperformed most endowments and hedge funds over the medium and longer term.

And, if a structure is set, quarterly rebalancing also has been shown to enhance returns.

Simple structures and rules prepared in advance can help to avoid panic decisions.

BWB

The information set out herein has been obtained from various public sources and is by way of information only. Broadgate Financial can accept no liability of any sort in relation thereto and readers should obtain their own verification of any statement before making any decision which may have any financial or other impact.

Neither the information nor the opinions herein constitute, or are they to be construed as, an offer or a solicitation of an offer to buy or sell investments.

clientservices@broadgatefinancial.com