Family Wealth Management: Renewed Fears All Eyes On The US And Europe - Autumn 2011



It never rains...

Economic turmoil has plagued the media headlines of late, as country after country has fallen victim to stagnant growth, soaring debts and deficit problems.

There was a unanimous sigh of relief across Europe when the Greek parliament voted to accept new austerity measures. But news of sluggish second-quarter growth in the UK and growing contagion risks to Italy and Spain were quick to dampen spirits once again.

Across the pond, the US wasn't faring much better. Tense negotiations between President Obama's administration and the Republicans over the extension of the debt ceiling and deficit reduction programme went down to the wire. Extending the debt ceiling was the only possible answer – but the 11th-hour brinkmanship was to be expected.

In light of recent events, it is perhaps not surprising that this issue of Family Wealth Management focuses on the continued global economic uncertainty. As well as our regular look at the global markets in our investment outlook article, we ask if the US dollar will remain the reserve currency in the wake of the country's financial troubles. We also travel further afield to the Asian markets to find out if the Asian bubble will burst or gently deflate.

Closer to home, IHT could soon be in the spotlight. Speculation that HMRC is set to zone in on IHT liabilities could see unsuspecting executors in the frame. Concern that IHT reliefs may also be reviewed means now is a good time to get your affairs in order, alleviating the potential burden on loved ones.

Finally, high net worth individuals may be interested in our article on membership of Lloyd's as an alternative asset class, while higher earners in danger of going over the lifetime allowance for pensions should read how to avoid a substantial tax charge.


World: hit by a double whammy

The markets rapidly rotated to an aggressive 'risk off' position in August in response to a double whammy of concerns – the display of alarmingly dysfunctional political leadership on either side of the Atlantic, together with mounting concerns over the fragility of the US economy. Consequently, global equities contracted 13% in rapid order, Gold moved from $1628 to just shy of $1900 and US and UK bond yields approached all time lows.

While it is tempting to treat the sell off as an attractive entry point we need to acknowledge that the decline in the bond yields is posing major questions over the trajectory of growth, and therefore returns, expected from equities. The connectivity between nominal bond yields and nominal gross domestic product (GDP) growth suggests we have entered the stage of the cycle when operating leverage (the impact that a shift in revenue growth has on earnings) turns negative. Consequently a health warning needs to be attached to what appear to be apparently low market valuations – 2012 EPS forecasts look set to ratchet lower.

As in 2009 and 2010, policy initiatives and macro factors, not valuations, will be the catalysts for a recovery in equities. Much attention is therefore focused on whether Federal Reserve chairman Ben Bernanke can rally the market and sentiment. Unfortunately, he is more constrained in his policy options compared to last year. Therefore a 2010 redux is unlikely. The other policy response that would have a major market impact would be a signal of co-ordinated action in the eurozone (particularly a German acceptance of a move towards fiscal union and the establishment of eurozone bonds). This feels like hope rather than expectation. Until we get clarification on the status of the US economy and the eurozone debt crisis, markets are likely to remain volatile.

UK: QE2 on the radar screen

The UK economy is losing momentum. Consumption expenditure remains extremely fragile and is unlikely to rebound sharply. It has been impacted by sustained erosion in real disposable income and a deteriorating labour market. The housing market remains moribund. Net exports have failed to accelerate and with government expenditure contracting, corporate capital expenditure is the only visible source of growth stimulus. Growth projections of 1.7% (2011) and 2.5% (2012) are now looking optimistic. The chancellor has acknowledged that the recovery will be "longer and harder" than expected. It also poses questions over the sustainability of the austerity programme. UK gilt yields have hit their lowest level since the 19th century.

The August Monetary Policy Committee (MPC) minutes reflected mounting concern over the economy – no member voted for a rate hike. There was also consideration of whether there was a case for extending quantitative easing (QE) – a clear signal that further QE is on the radar screen and will be deployed if downside risks materialise.


Can the US dollar maintain its position as the reserve currency given the state of the US economy?

A reserve currency is one that is commonly held in significant quantities by foreign governments and institutions as part of their accumulated foreign exchange reserves. The dominant reserve currency also tends to be the pricing currency for products traded on a global market.

History of the reserve currency

A currency may remain the de facto reserve currency for years – if not decades. But history has shown that every now and again it loses its status and is replaced with an alternative currency. For instance, in the 18th and 19th centuries, sterling was the key reserve currency. However, when the UK accumulated significant debt following both world wars, the reserve currency mantle shifted to the US dollar.

The dollar has been the primary reserve currency for the past 60 years. Most commodities are still priced in dollars and it accounts for 60% of aggregated currency reserves (the euro and sterling account for 30% and 5%, respectively). The key question though is: are we witnessing an unwinding of the dollar hegemony?

US woes

The parlous state of the US fiscal deficit, the downgrade of US debt ratings and fears that two doses of quantitative easing will debase fiat currency (money declared to be legal tender by a government, but with no intrinsic value), are understandably raising questions about the role of the dollar as a reserve currency.

China decides

Ultimately, the People's Bank of China will determine whether or not the dollar remains the key reserve currency. The Chinese have the largest global currency reserves, totalling some $3.2trn – almost three times the size of the next biggest holding. These reserves have mushroomed as a result of China maintaining the yuan peg at a low enough level to drive export growth and accumulate trade surpluses.

With almost 70% of their reserves held in dollar assets, the Chinese are keen to diversify their currency exposure. Their dilemma is that the euro – the only other practical reserve currency option – is facing significant systemic risks of its own. Consequently, while the Chinese have voiced their support for the euro and invested in peripheral European bonds, the high levels of uncertainty surrounding the sustainability of the euro means for the foreseeable future they are unlikely to shift their reserve currency exposure significantly.

Longer term, once the Chinese yuan is allowed to float freely on foreign exchange markets, there is scope for it to become a reserve currency in its own right, but this is several years away. Until then, despite losing some of its dominance, the dollar is likely to remain the global reserve currency.

Historical timeline of dominant international currencies


Is there an Asian bubble and are fears that it will burst justified?

Asian markets led the recovery out of the global financial crisis. They were in a far stronger position than developed markets, which were only just beginning the painful process of deleveraging.

Strong performance

By the end of...

To continue reading