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It’s always dangerous to over-interpret what can happen in thin markets in the second half of December, but the recent environment may be best described as having been patchily risk-on. This has been most evident in equity markets, with European equities up 7% in the second half of the month, US and UK equities up by 3-4% and emerging equities in general up but by less than in developed markets.

We think 2012 will be a year of relatively subdued economic growth and declining inflation, and a year in which monetary policymakers are likely to have to take up much of the running in providing stimulus to a slow-growing global economy. We know that towards the end of last year continental Europe was in recession, and this was having a discernible impact on the already weak UK economy. The main exception to this rather difficult background has been the US, which clearly re-accelerated in the second half of last year after the first-half slowdown.

There is likely to be significant fall in headline inflation, partly because of slow growth, partly because of a significant level of excess capacity, but also because the recent flatter trend in commodities, which if maintained (as we expect) is likely to lead to some favourable comparisons. The third and final theme is likely to be the importance of policy. Much hinges here on the European Central Bank’s continued efforts to stabilise the sovereign debt crisis in Europe. In terms of US and UK monetary conditions, there is likely to be additional quantitative easing as the year goes on.

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Focus on Fixed Income

Update on the fixed income landscape covering government and corporate bonds and currency moves.

Precious Metals Update

Despite a brief pre-Christmas rally to back over $1,600/oz, gold continued to fall during the holiday season and was last trading at $1,531/oz. Read more detail.

Global Strategic Framework

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Market Movements Table

The European Union (EU) summit meeting has resulted in agreement among most of the 27 member states, although not the UK.

  • The announcement thus far leaves many of the details unresolved. However, broad agreement has been reached on additional support for indebted sovereigns and fiscal reform.
  • The operation of the European Stability Mechanism (ESM) is being brought forward and will now come into force in July 2012 – it had originally been scheduled for July 2013. This means that it can run parallel with the European Financial Stability Facility (EFSF) for some time, until mid-2013. From that point on the ESM will be responsible for new programmes. The prospect of private sector haircuts within economies that require ESM assistance appears to have receded.
  • In March next year the €500 billion ceiling for the EFSF and ESM will be reviewed and, if necessary, capital payments into the ESM could be brought forward.
  • Up to €200 billion of additional bilateral loans may be provided to the International Monetary Fund (IMF), with the majority likely to be provided by the central banks of eurozone member states.
  • Fiscal governance measures will be incorporated into the relevant treaties, although the details are yet to be announced. A new fiscal rule that general government budgets should be balanced or in surplus will be adopted, with deviants subject to an automatic correction mechanism. Furthermore, the rule that a state with a debt-to-GDP ratio greater than 60% must remove the excess at a pace of one-twentieth a year will be enshrined in the new provisions.
  • If a nation’s budget deficit grows larger than the 3% of GDP deficit ceiling then, unless a majority of member states disagree, automatic sanctions will be imposed. The exact nature of these sanctions is yet to be revealed.
  • If agreement is not reached between all 27 EU member states then ‘enhanced cooperation’ will be used to create a new treaty only amongst those that do agree.
  • In a very busy week for European announcements, the European Banking Authority (EBA) revealed the results of stress tests for the banking system. 71 of the region’s banks have a capital shortfall totalling €115 billion, with the German shortfall amounting to €13 billion. Spanish banks need to find an additional €26 billion[1].
  • Yesterday the European Central Bank (ECB) lowered the target refinancing rate by 25 basis points to 1.00% and announced some additional ‘extraordinary measures’ aimed at addressing the funding pressures in Europe. (For further details please see yesterday’s bullet). 

Comments from Scott Thiel, Deputy Chief Investment Officer of Fundamental Fixed Income:

  • The EU has moved toward a genuine ‘fiscal stability union’. These steps include stronger fiscal rules, greater policy coordination, more robust governance, and strengthening of the stability rules. We applaud these efforts and agree that if implemented, these steps would improve the fundamentals of European Monetary Union.
  • At the same time, we remain concerned about the gap between the time required to implement such measures and the quick fix required by market participants. As such, we view the additional liquidity measures put forth at the ECB and the continuation of the Securities Markets Programme as critical in enabling liquidity to return to the European capital markets. Banking pressures clearly remain but policies are being put in place to help.
  • Overall, the initial output of the EU Summit and the ECB meeting continue to reinforce our view that policy makers understand the gravity of the situation and are working hard within the confines of the EU’s political structure to permanently address investors’ concerns.

1. EBA 8 December 2011
All other data source: BlackRock DataStream December 2011    

This material is for distribution to Professional Clients and should not be relied upon by any other persons. Research in this document has been produced and may been acted on by BlackRock for its own purposes. The views expressed do not constitute investment advice and are subject to change. All financial investments involve an element of risk. Therefore, the value of your investment and the income from it will vary and your initial investment amount cannot be guaranteed. Past performance is not a guide to future performance and should not be the sole factor of consideration when selecting a product. Issued by BlackRock Investment Management (UK) Limited (authorised and regulated by the Financial Services Authority). Registered office: 12 Throgmorton Avenue, London, EC2N 2DL. Registered in England No. 2020394. Tel: 020 7743 3000. For your protection, telephone calls are usually recorded. BlackRock is a trading name of BlackRock Investment Management (UK) Limited.

For distribution in EMEA for Professional Investors only, or “professional clients”, as such term may apply in relevant jurisdictions. UAE: BlackRock Advisors (UK) Limited is regulated by the Dubai Financial Services Authority in the DIFC and authorised and regulated by the Financial Services Authority in the UK, has issued this document for access by Professional Clients and no other person should rely upon them information contained within it. The financial services to which the document relates are only available to Professional Clients. Dubai: BlackRock Advisors (UK) Limited which is regulated by the Dubai Financial Services Authority in the DIFC and authorised and regulated by the Financial Services Authority in the UK, has issued this document for access by Professional Clients and no other person should rely upon them information contained within it. The financial services to which the document relates are only available to Professional Clients. Saudi Arabia: The financial services to which the document relates may only be offered and sold in the Kingdom of Saudi Arabia in accordance with Article 4 of the Investment Funds Regulations issued on December 24, 2006 (the “Regulations”) Article 4(b)(4) of the Regulations states that, if investment fund units are offered to no more than 200 clients in the Kingdom of Saudi Arabia and the minimum amount payable per client is not less than SAR 1 million or an equivalent amount in another currency, such offer of investment fund units shall be deemed a private placement for purposes of regulation. Investors are informed that Article 4(g) of the Regulations places restrictions on secondary market activity with respect to such investment fund units. Kuwait: This document is not for general circulation to the public in Kuwait nor will the fund be sold to the public in Kuwait. The fund has not been licensed for offering in Kuwait. Bahrain: The fund represents and warrants that it has not made and will not make any invitation to the public in the Kingdom of Bahrain to subscribe to the interests in the fund and that this document will not be issued, disseminated, or made available to the public generally. Qatar: Persons or entities to whom this document has been issued understands, acknowledges and agrees that this document has not been approved by the Qatar Central Bank, or any other government agency or authority in Qatar. Oman: Persons or entities to whom this document has been issued understands, acknowledges, and agrees that his document has not been registered or approved by the Central Bank of Oman or any other government agency or authority in Oman. In Japan, not for use with individual investors. This material is being distributed/ issued in Canada, Australia and New Zealand by BlackRock Financial Management, Inc. ("BFM"), which is registered as an International Advisor with the Ontario Securities Commission. In addition, BFM is a United States domiciled entity and is exempted under Australian CO 03/1100 from the requirement to hold an Australian Financial Services License and is regulated by the Securities and Exchange Commission under US laws which differ from Australian laws. In New Zealand, this presentation is offered to institutional and wholesale clients only. It does not constitute an offer of securities to the public in New Zealand for the purpose of New Zealand securities law. BFM believes that the information in this document is correct at the time of compilation, but no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BFM, its officers, employees or agents. This document contains general information only and is not intended to be relied upon as a forecast, research, investment advice, or a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The information does not take into account your financial circumstances. An assessment should be made as to whether the information is appropriate for you having regard to your objectives, financial situation and needs.


 

The Governing Council of the European Central Bank (ECB) has voted to cut the benchmark interest rate by 0.25% to 1.0%.

  • The ECB lowered their target refinancing rate by 25 basis points to 1.00%, along with a commensurate reduction in the interest rate on the ECB’s deposit facility from 0.50% to 0.25% and the marginal lending facility from 2.00% to 1.75%.This is the second month in a row in which the ECB has reduced interest rates.
  • ECB President Mario Draghi also announced some additional ‘extraordinary measures’ during the press conference aimed at addressing the bank funding pressures in Europe. These include a loosening of the rules on accepted collateral and offering, for the first time, three-year liquidity tenders to banks with full allotment (with the option of early repayment after one year). This three-year funding will replace the planned 12-month tenders. Furthermore, the ECB reduced the reserve requirement ratio that lenders must hold with their national central banks to 1% (down from 2%).
  • Regarding collateral, the ECB has reduced the rating threshold for certain asset-backed securities (ABS) and will temporarily allow national central banks to accept additional bank loans that satisfy certain criteria as collateral.
  • Draghi also announced significant downgrades to the ECB’s forecasts for GDP growth, suggesting a range of -0.4% to 1.0% for 2012 and 0.3% to 2.0% for 2013. Meanwhile, inflation is now expected to be 1.5% to 2.5% in 2012. For the first time, the ECB provided a forecast of 2013 inflation, which they see between 0.8% and 2.2%.
  • In the question and answer session following the initial statement, Draghi emphasised that the ECB is not legally allowed to provide monetary financing to individual eurozone member states, casting doubt on an expanded Securities Markets Programme (SMP) or financing International Monetary Fund (IMF) lending to the EMU.

Background

  • The Governing Council met in the shadow of the EU summit meeting that is now taking place. Markets are eagerly awaiting the outcome of that crisis meeting, with investors hoping that it will go some way to laying the foundations for a sustainable and credible solution to the sovereign debt crisis.
  • Ratings agency Standard & Poor’s (S&P) put the long-term debt of 15 eurozone nations on CreditWatch negative at the start of this week, including AAA-rated Germany, Austria, France, Finland, the Netherlands and Luxembourg. In addition, S&P has also placed several European banks and the European Financial Stability Facility (EFSF) on negative watch. The move has put further pressure on European policymakers to find some sort of resolution for the sovereign debt crisis at the summit.
  • In an unexpected move last week to boost liquidity, the ECB coordinated with the US Federal Reserve and four other central banks (Bank of England, Bank of Japan, Bank of Canada and Swiss National Bank) to reduce the price of the temporary dollar swap agreements by 50 basis points.

Deteriorating Economic Data

  • The flash estimate for annual HICP inflation remained stable in November at the three-year high of 3.0%[1]. Inflation has now remained above the ECB’s target of “close to but below 2%” for some time.
  • Since the last monetary policy announcement in October, at which the benchmark, deposit facility and marginal lending facility interest rates were all cut by 0.25%, economic data releases have continued to suggest a significant moderation in economic growth across the eurozone.
  • Purchasing Managers’ Index (PMI) data have continued to weaken, with both the manufacturing and services PMIs remaining below the important 50-level in November[2]. A figure below 50 is generally viewed as signalling contraction. The manufacturing PMI fell to 46.4, a 28-month low, while the services PMI increased slightly to 47.5. The composite index recorded 47.0 in November, with Germany falling back below 50 for the first time since July 2009 (at 49.4) and Spain registering a 32-month low of 38.2.
  • According to the accompanying report by Markit: “The final PMI numbers indicate that the eurozone contracted for the third successive month in November, putting the region on course for an economic contraction of approximately 0.6% in the final quarter of the year.”
  • The region’s unemployment rate deteriorated further in October, rising to 10.3%[3]. Spain continued to have the highest unemployment rate, at 22.8%, followed by Greece (at 18.3% in August). Austria remained the lowest, at 4.1%. Eurozone youth unemployment (under 25 years old) increased to 21.4% in October. The youth unemployment rates in Spain and Greece are now a worrying 48.9% and 45.1% respectively. 
  • Not all data have been disappointing. German industrial production expanded by 0.8% m/m in October (and 4.1% y/y)[4], after contracting by 2.8% m/m in September. German factory orders also exceeded consensus expectations, growing by 0.3% m/m in October.

Comments from Scott Thiel, Deputy Chief Investment Officer of Fundamental Fixed Income:

  • Although the market expected the reduction in the refinancing rate, the number and scope of additional measures came as somewhat of a surprise. Together, these measures are aimed at providing additional easing of bank funding pressures in Europe. In particular, the drop in the deposit ratio and the ability for banks to finance lower-rated ABS and loans should provide additional stimulus to the banking sector – stimulus which the ECB is keen to be passed on to the business sector and especially the small business sector.
  • Overall, we view these steps as positive – particularly as they were delivered before the EU summit taking place over the next two days. The market was disappointed by the President’s reluctance to promise additional bond purchases, but we would view that as short sighted.
  • The ECB has done its part and now it is time for policy makers to do theirs. The entire situation remains very political and thus very binary.

1. Eurostat 30 November 2011
2. Markit December 2011
3. Eurostat 30 November 2011
4. German economic ministry 7 December 2011
All other data source: BlackRock DataStream December 2011

This material is for distribution to Professional Clients and should not be relied upon by any other persons. Research in this document has been produced and may been acted on by BlackRock for its own purposes. The views expressed do not constitute investment advice and are subject to change. All financial investments involve an element of risk. Therefore, the value of your investment and the income from it will vary and your initial investment amount cannot be guaranteed. Past performance is not a guide to future performance and should not be the sole factor of consideration when selecting a product. Issued by BlackRock Investment Management (UK) Limited (authorised and regulated by the Financial Services Authority). Registered office: 12 Throgmorton Avenue, London, EC2N 2DL. Registered in England No. 2020394. Tel: 020 7743 3000. For your protection, telephone calls are usually recorded. BlackRock is a trading name of BlackRock Investment Management (UK) Limited. For distribution in EMEA for Professional Investors only, or “professional clients”, as such term may apply in relevant jurisdictions. UAE: BlackRock Advisors (UK) Limited is regulated by the Dubai Financial Services Authority in the DIFC and authorised and regulated by the Financial Services Authority in the UK, has issued this document for access by Professional Clients and no other person should rely upon them information contained within it. The financial services to which the document relates are only available to Professional Clients. Dubai: BlackRock Advisors (UK) Limited which is regulated by the Dubai Financial Services Authority in the DIFC and authorised and regulated by the Financial Services Authority in the UK, has issued this document for access by Professional Clients and no other person should rely upon them information contained within it. The financial services to which the document relates are only available to Professional Clients. Saudi Arabia: The financial services to which the document relates may only be offered and sold in the Kingdom of Saudi Arabia in accordance with Article 4 of the Investment Funds Regulations issued on December 24, 2006 (the “Regulations”) Article 4(b)(4) of the Regulations states that, if investment fund units are offered to no more than 200 clients in the Kingdom of Saudi Arabia and the minimum amount payable per client is not less than SAR 1 million or an equivalent amount in another currency, such offer of investment fund units shall be deemed a private placement for purposes of regulation. Investors are informed that Article 4(g) of the Regulations places restrictions on secondary market activity with respect to such investment fund units. Kuwait: This document is not for general circulation to the public in Kuwait nor will the fund be sold to the public in Kuwait. The fund has not been licensed for offering in Kuwait. Bahrain: The fund represents and warrants that it has not made and will not make any invitation to the public in the Kingdom of Bahrain to subscribe to the interests in the fund and that this document will not be issued, disseminated, or made available to the public generally. Qatar: Persons or entities to whom this document has been issued understands, acknowledges and agrees that this document has not been approved by the Qatar Central Bank, or any other government agency or authority in Qatar. Oman: Persons or entities to whom this document has been issued understands, acknowledges, and agrees that his document has not been registered or approved by the Central Bank of Oman or any other government agency or authority in Oman. In Japan, not for use with individual investors. This material is being distributed/ issued in Canada, Australia and New Zealand by BlackRock Financial Management, Inc. ("BFM"), which is registered as an International Advisor with the Ontario Securities Commission. In addition, BFM is a United States domiciled entity and is exempted under Australian CO 03/1100 from the requirement to hold an Australian Financial Services License and is regulated by the Securities and Exchange Commission under US laws which differ from Australian laws. In New Zealand, this presentation is offered to institutional and wholesale clients only. It does not constitute an offer of securities to the public in New Zealand for the purpose of New Zealand securities law. BFM believes that the information in this document is correct at the time of compilation, but no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BFM, its officers, employees or agents. This document contains general information only and is not intended to be relied upon as a forecast, research, investment advice, or a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The information does not take into account your financial circumstances. An assessment should be made as to whether the information is appropriate for you having regard to your objectives, financial situation and needs.

The UK Monetary Policy Committee (MPC) has opted to leave base rates unchanged at 0.5% and to maintain its Asset Purchase Programme (quantitative easing) at £275 billion.

  • The decision was made against a backdrop of persistently high inflation and generally weak economic data in the UK, in addition to the ongoing turmoil in financial markets relating to the sovereign debt crisis in peripheral Europe.
  • All eyes are now on the European Central Bank’s monetary policy announcement, due this afternoon, and the European Union summit meeting which is taking place today and tomorrow.

Background

  • In its latest quarterly Inflation Report[1], the Bank of England (BoE) revised down its forecasts for both growth and inflation. The MPC believe that real GDP growth will be virtually flat over the next few quarters, while inflation will fall below target over the next two to three years. The eurozone sovereign debt crisis is believed to pose the biggest risk to UK economic recovery.
  • CPI inflation remains significantly above the BoE’s 2% target, registering 5.0% year on year (y/y) in October[2], down from 5.2% in September. Meanwhile, the Citi/YouGov poll conducted in November showed that inflation expectations for the year ahead have declined slightly to 3.1%[3]. However, expectations for the longer term (5-10 years) rose to 3.5% y/y in November.
  • The minutes from the November MPC meeting showed that the decisions to maintain Bank Rate at 0.5% and keep the Asset Purchase Programme unchanged[4] were both unanimous. However, the minutes did note “a further expansion of the asset purchase programme might well become warranted in due course”.
  • The BoE joined in a coordinated agreement with the US Federal Reserve, the Bank of Canada, the Bank of Japan, the European Central Bank and the Swiss National Bank to provide cheap US dollar loans to European banks via a 50bp reduction in US dollar swap lines between the Fed and other central banks.
  • The BoE has announced an additional tool aimed at helping to provide liquidity – the Extended Collateral Term Repo Facility (ECTR). Under this scheme the BoE can announce auctions one day ahead for 30-day sterling loans in response to exceptional market stress.

Weak Economic Data

  • Purchasing managers’ index (PMI) data have remained weak but nevertheless exceeded expectations. The services PMI rose from 51.3 in October to 52.1 in November, while the manufacturing index declined slightly to 47.6 in November (down from 47.8). A figure below 50 is generally viewed as signalling contraction.
  • Manufacturing output contracted by 0.7% m/m in October and grew by just 0.3% y/y[5]. This was worse than consensus expectations and helped to pull down industrial production, which also declined by 0.7% m/m in October and fell by 1.7% y/y.
  • The value of like-for-like retail sales declined by 1.6% y/y in November and total sales increased by 0.7%.  The unseasonably mild weather was cited as one of the reasons for the weaker than expected sales[6]. 
  •  The Office of Budget Responsibility (OBR) reduced its GDP growth forecasts, changing its 2011 forecast to 0.9% and predicting 0.7% growth for 2012.  It also increased its expectation for overall borrowing between now and financial year 2015/16 to £105 billion[7].
  • Subsequently, in his Autumn Statement, Chancellor of the Exchequer George Osborne kept his fiscal plans for the next few years neutral overall, but announced some extra tightening measures from 2015. The Chancellor did, however, announce measures designed to support the economy in the short term, including a credit easing programme in which the government will guarantee bank lending to small and medium enterprises (SMEs). The scheme is divided into two segments, the National Loan Guarantee Scheme (worth £20 billion initially) and the Business Finance Partnership (worth an initial £1 billion).
  • Osborne also announced extra expenditure on infrastructure, an extension of the holiday on small business tax rates and a more graduated increase in fuel duty. In contrast, he also revealed a higher bank levy, pension tax changes and less generous working tax credits.  
  • Labour market data releases deteriorated in November, with the unemployment rate for the three months to September rising to 8.3%[8]. This is the highest rate of unemployment since 1996, while the total number (2.62 million) is the highest since 1994. Youth unemployment (ages 16-24) has risen to 21.9% - the highest since comparable records began in 1992. 

Comments from Ian Winship, Head of Sterling Bond Portfolios within BlackRock's Fundamental Fixed Income Team:

  • The BoE remains deeply concerned over the current difficulties in funding markets. This is reflected in the addition of the ECTR to its liquidity provision measures, which will enable it to respond quickly to market stresses. Under the ECTR, the BoE can offer 30-day loans, via auctions announced one day in advance, against the extended set of collateral with a minimum bid of 125bp above Bank Rate.
  • The Inflation Report and the minutes from the previous MPC also suggest that there is plenty of scope for the Bank of England to increase its Asset Purchase Programme above the £275 billion current limit.
  • Financial market turmoil stemming from the eurozone, together with the weak growth prospects for that region, continue to pose significant risks and headwinds for the UK economy. However, a return to recession is not our base case for the UK and we can but hope that this week’s EU summit goes some way to putting in place the foundations for a resolution of the sovereign debt crisis.


1. Bank of England (BoE) 16 November 2011
2. Office for National Statistics (ONS) 15 November 2011
3. YouGov November 2011
4. BoE 23 November 2011
5. ONS 7 December 2011
6. BRC 6 December 2011
7. OBR 29 November 2011
8. ONS 16 November 2011
All other data source: BlackRock DataStream December 2011    

This material is for distribution to Professional Clients and should not be relied upon by any other persons. Research in this document has been produced and may been acted on by BlackRock for its own purposes. The views expressed do not constitute investment advice and are subject to change. All financial investments involve an element of risk. Therefore, the value of your investment and the income from it will vary and your initial investment amount cannot be guaranteed. Past performance is not a guide to future performance and should not be the sole factor of consideration when selecting a product. Issued by BlackRock Investment Management (UK) Limited (authorised and regulated by the Financial Services Authority). Registered office: 12 Throgmorton Avenue, London, EC2N 2DL. Registered in England No. 2020394. Tel: 020 7743 3000. For your protection, telephone calls are usually recorded. BlackRock is a trading name of BlackRock Investment Management (UK) Limited.

For distribution in EMEA for Professional Investors only, or “professional clients”, as such term may apply in relevant jurisdictions. UAE: BlackRock Advisors (UK) Limited is regulated by the Dubai Financial Services Authority in the DIFC and authorised and regulated by the Financial Services Authority in the UK, has issued this document for access by Professional Clients and no other person should rely upon them information contained within it. The financial services to which the document relates are only available to Professional Clients. Dubai: BlackRock Advisors (UK) Limited which is regulated by the Dubai Financial Services Authority in the DIFC and authorised and regulated by the Financial Services Authority in the UK, has issued this document for access by Professional Clients and no other person should rely upon them information contained within it. The financial services to which the document relates are only available to Professional Clients. Saudi Arabia: The financial services to which the document relates may only be offered and sold in the Kingdom of Saudi Arabia in accordance with Article 4 of the Investment Funds Regulations issued on December 24, 2006 (the “Regulations”) Article 4(b)(4) of the Regulations states that, if investment fund units are offered to no more than 200 clients in the Kingdom of Saudi Arabia and the minimum amount payable per client is not less than SAR 1 million or an equivalent amount in another currency, such offer of investment fund units shall be deemed a private placement for purposes of regulation. Investors are informed that Article 4(g) of the Regulations places restrictions on secondary market activity with respect to such investment fund units. Kuwait: This document is not for general circulation to the public in Kuwait nor will the fund be sold to the public in Kuwait. The fund has not been licensed for offering in Kuwait. Bahrain: The fund represents and warrants that it has not made and will not make any invitation to the public in the Kingdom of Bahrain to subscribe to the interests in the fund and that this document will not be issued, disseminated, or made available to the public generally. Qatar: Persons or entities to whom this document has been issued understands, acknowledges and agrees that this document has not been approved by the Qatar Central Bank, or any other government agency or authority in Qatar. Oman: Persons or entities to whom this document has been issued understands, acknowledges, and agrees that his document has not been registered or approved by the Central Bank of Oman or any other government agency or authority in Oman. In Japan, not for use with individual investors. This material is being distributed/ issued in Canada, Australia and New Zealand by BlackRock Financial Management, Inc. ("BFM"), which is registered as an International Advisor with the Ontario Securities Commission. In addition, BFM is a United States domiciled entity and is exempted under Australian CO 03/1100 from the requirement to hold an Australian Financial Services License and is regulated by the Securities and Exchange Commission under US laws which differ from Australian laws. In New Zealand, this presentation is offered to institutional and wholesale clients only. It does not constitute an offer of securities to the public in New Zealand for the purpose of New Zealand securities law. BFM believes that the information in this document is correct at the time of compilation, but no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BFM, its officers, employees or agents. This document contains general information only and is not intended to be relied upon as a forecast, research, investment advice, or a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The information does not take into account your financial circumstances. An assessment should be made as to whether the information is appropriate for you having regard to your objectives, financial situation and needs.

 

The Bank of England (BoE) has revised down its forecasts for growth and inflation in the latest quarterly Inflation Report. 

  • A downbeat tone to the Inflation Report was set from the first line: “The prospects for the UK economy have worsened.” High levels of uncertainty surrounding the potential paths for both growth and inflation were also emphasised throughout the report.
  • The Monetary Policy Committee (MPC) believe that real GDP growth will be virtually flat over the next few quarters, while inflation will fall below target over the next two to three years.  Both the Inflation Report and comments in the press conference by Governor Mervyn King stress the negative impact of the eurozone sovereign debt crisis and the need for a credible and effective policy response.
  • Last week the MPC opted to leave base rates unchanged at 0.5% and to maintain its Asset Purchase Programme (quantitative easing) at £275 billion. Bank Rate has remained at the historically low level of 0.5% since March 2009. (Please see the ‘Bullet on the MPC’s Monetary Policy Decision’, dated 10 November, for further details).

Reduced Growth Forecast

  • On growth, the report notes that the outlook is unusually uncertain, reflecting the UK economy’s exposure to the eurozone. It also states that the outlook for growth over the next year has deteriorated significantly since the last Inflation Report was published in August.
  • The BoE expects growth to be weak in the near term. The slowdown in global demand, heightened concerns about the solvency of several eurozone governments, increased strains in funding markets and declines in household and business confidence are all cited as contributors to weak UK growth. “These factors, along with the fiscal consolidation and squeeze on households’ real incomes, are likely to weigh heavily on UK growth in the near term.”
  • However, the BoE expects that the economic recovery is “likely to gather pace over the second and third years of the forecast as private demand picks up, supported by continuing stimulus from monetary policy and a gentle recovery in real incomes.”
  • The eurozone sovereign debt crisis is believed to pose the biggest risk to UK economic recovery.
  • This morning’s release of labour market data showed further deterioration and underperformed consensus expectations. In the labour force survey measure of unemployment (ILO), the rate increased to 8.3% in the three months to September, up from 8.1%[1]. With 2.62 million unemployed people, this is the highest level since 1994.

Inflation Expected to Fall

  • CPI inflation remains significantly above the BoE’s 2% target. However, it fell slightly in October to 5.0% year on year (y/y)[2], down from 5.2% in September. The decline in the headline inflation rate was largely due to a drop in food price inflation.
  • According to the Inflation Report, the BoE expects CPI inflation to decline sharply in 2012 and to fall below target over the next couple of years. This is based on slack in the labour market and on reduced contributions to inflation from VAT, energy and import prices. The increase in the VAT rate to 20% is estimated to have added about 1% to inflation this year.
  • Again, the report stresses uncertainty and a range of views among Committee members regarding the outlook for the pace and size of the predicted decline in inflation.

Comments from Ian Winship, Head of Sterling Bond Portfolios within BlackRock's Fundamental Fixed Income Team:

  • As expected, this was a pretty dovish report that contained a lot of references to the risks to both UK and European economic growth emanating from the eurozone sovereign debt crisis.
  • The BoE has substantially reduced its forecasts. Growth is now expected to be slightly less than 1% by mid-2012, down from 2.25% in the August report. Meanwhile, the low point of inflation was brought down to 1.5% at the forecast horizon.
  • The risk of recession in the UK is deemed to have increased since the August Inflation Report.
  • As reported by the newswires, we should expect additional QE. The BoE have given themselves a lot of wiggle room to either maintain or increase the amount of stimulus and will continue with their current policy strategy until light appears at the end of the tunnel.

1. Office for National Statistics (ONS) 16 November 2011
2. ONS 15 November 2011
All other data source: BlackRock DataStream November 2011

This material is for distribution to Professional Clients and should not be relied upon by any other persons. Research in this document has been produced and may been acted on by BlackRock for its own purposes. The views expressed do not constitute investment advice and are subject to change. All financial investments involve an element of risk. Therefore, the value of your investment and the income from it will vary and your initial investment amount cannot be guaranteed. Past performance is not a guide to future performance and should not be the sole factor of consideration when selecting a product. Issued by BlackRock Investment Management (UK) Limited (authorised and regulated by the Financial Services Authority). Registered office: 12 Throgmorton Avenue, London, EC2N 2DL. Registered in England No. 2020394. Tel: 020 7743 3000. For your protection, telephone calls are usually recorded. BlackRock is a trading name of BlackRock Investment Management (UK) Limited. For distribution in EMEA for Professional Investors only, or “professional clients”, as such term may apply in relevant jurisdictions. In Japan, not for use with individual investors. This material is being distributed/issued in Canada, Australia and New Zealand by BlackRock Financial Management, Inc. ("BFM"), which is registered as an International Advisor with the Ontario Securities Commission. In addition, BFM is a United States domiciled entity and is exempted under Australian CO 03/1100 from the requirement to hold an Australian Financial Services License and is regulated by the Securities and Exchange Commission under US laws which differ from Australian laws. In New Zealand, this presentation is offered to institutional and wholesale clients only. It does not constitute an offer of securities to the public in New Zealand for the purpose of New Zealand securities law. BFM believes that the information in this document is correct at the time of compilation, but no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BFM, its officers, employees or agents. This document contains general information only and is not intended to be relied upon as a forecast, research, investment advice, or a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The information does not take into account your financial circumstances. An assessment should be made as to whether the information is appropriate for you having regard to your objectives, financial situation and needs.

The UK Monetary Policy Committee (MPC) has opted to leave base rates unchanged at 0.5% and to maintain its Asset Purchase Programme (quantitative easing) at £275 billion.

  • The decision was made against a backdrop of persistently high inflation and generally weak economic data in the UK, in addition to the ongoing turmoil in financial markets relating to the sovereign debt crisis in peripheral Europe.

Background – High Inflation and October MPC minutes

  • Last month the MPC decided to restart quantitative easing, increasing its asset purchase programme by £75bn to £275bn. Bank Rate has remained at the historically low level of 0.5% since March 2009.
  • CPI inflation remains significantly above the Bank of England (BoE)’s 2% target. It rose sharply in September to 5.2% year on year (y/y), up from 4.5% in August[1], and now equals the record-high level reached in September 2008. The largest contributor to the rise in inflation came from increases in gas and electricity charges. However, the Citi/YouGov poll conducted in October showed that inflation expectations for the year ahead have declined slightly to 3.4%[2], from 3.5% in September. Furthermore, expectations for the longer term (5-10 years) declined by 0.4% in October to 3.4% y/y.
  • The minutes from the October MPC meeting showed that the decisions to maintain Bank Rate at 0.5% and to increase the Asset Purchase Programme by £75bn[3] were both unanimous. Regarding the UK economy, the minutes were quite downbeat “the available indicators suggested that the underlying rate of growth had moderated and would be close to zero in the fourth quarter.”
  • The minutes also noted, “Short-term funding had become more expensive and difficult to obtain for European banks, including those in the United Kingdom… Credit default swap premia on banks’ unsecured debt had been volatile around elevated levels, and the term unsecured funding markets had remained virtually closed to new issuance.”
  • The BoE will release its next quarterly inflation report on 16 November.

Economic Data Generally Weaker

  • The preliminary estimate for third-quarter economic growth was above consensus expectations, at 0.5% q/q[4], and up from 0.1% q/q GDP growth in the second quarter. However, the Office for National Statistics noted in its accompanying statement that the Q3 data was boosted by the weak second quarter (which had been negatively impacted by special events such as the additional bank holiday for the royal wedding). Over the last year as a whole, the economy has grown by 0.5%.
  • Other economic data releases have, overall, been weak. In particular, purchasing managers’ index (PMI) data came in below consensus expectations in October. The manufacturing index declined to 47.4, from 50.8 in September, taking it below the important 50-level. A figure below 50 is generally viewed as signalling contraction. The services PMI also declined, to 51.3 in October from 52.9 in September.
  • In the Confederation of British Industry’s survey of manufacturing firms, the overall business confidence index fell sharply in October to -30, the weakest level since April 2009[5]. An increasing number of companies also reported that shortages of credit or finance are acting as a significant constraint on investment.
  • Labour market data releases also deteriorated in October. In the labour force survey, the unemployment rate increased to 8.1% in the three months to August[6]. The claimant count measure of unemployment also rose slightly, to 5.0% in September from 4.9% in August.
  • Perhaps not surprisingly, the GFK consumer confidence index declined in October to -32, from -30 in September.
  • Among the more positive data releases, the public sector net borrowing requirement (PSNB), or fiscal deficit, was better than consensus expectations at £14.1bn for September excluding financial interventions. Of particular note, the figure for August had been significantly revised down by over £2bn. It had been £15.4bn in September 2010. The public sector current budget deficit, excluding financial interventions, also outperformed, at £11.bn[7].
  • In the housing market, the Nationwide house price index[8] grew 0.4% m/m in October, after an increase of 0.1% in September. The Rightmove house price index[9] showed an even larger increase in October of 2.8% m/m, after rising by in September. Meanwhile, in the RICS housing market survey, the price balance declined by 0.4 to -23.2 in September, signifying that more surveyors reported price declines than increases. However, the balance of sales increased. 

Comments from Ian Winship, Head of Sterling Bond Portfolios within BlackRock's Fundamental Fixed Income Team:

  • The UK’s unexpected growth in Q3 was a welcome surprise, especially for the Chancellor, however it may owe more to the dampening of Q2 figures by one off events. We do not see this growth continuing into Q4, as weather conditions deteriorate. A sustained low growth environment looks set to continue but a return to recession is not our base case scenario.
  • The faltering UK economy is not all down to government austerity, but a general slowdown across Europe and the globe as a whole. The largest European economies also remain a source of real concern. Consensus economic forecasts for the eurozone as a whole point to zero growth in the fourth quarter, with the likelihood that these forecasts become more pessimistic in the coming weeks.
  • UK credit outperformed government bonds in October, led by financials and telecommunications, for the first time since April. This was a result of a brief “risk on” environment, after eurozone policymakers discussed new measures to reassure markets on October 21st. However, this proved short lived as political posturing soon put pay to any hopes of a resolution. 
  • The issue hasn’t changed – the market perceives that global governments (in Europe and the US) have still not done enough to ensure the foundation of the sovereign and financial sectors, yet there is no sense that leaders “get it” despite constant cajoling by the US and international markets. As a result risk assets continue, and will likely continue to trade, with extreme volatility.


1. Office for National Statistics (ONS) 18 October 2011
2. YouGov October 2011
3. BoE 19 October 2011
4. ONS 1 November 2011
5. ONS October 2011
6. ILO October 2011
7. ONS 21 October 2011
8. Nationwide November 2011
9. Rightmove 17 October 2011


All other data source: BlackRock DataStream November 2011  

This material is for distribution to Professional Clients and should not be relied upon by any other persons. Research in this document has been produced and may been acted on by BlackRock for its own purposes. The views expressed do not constitute investment advice and are subject to change. All financial investments involve an element of risk. Therefore, the value of your investment and the income from it will vary and your initial investment amount cannot be guaranteed. Past performance is not a guide to future performance and should not be the sole factor of consideration when selecting a product. Issued by BlackRock Investment Management (UK) Limited (authorised and regulated by the Financial Services Authority). Registered office: 12 Throgmorton Avenue, London, EC2N 2DL. Registered in England No. 2020394. Tel: 020 7743 3000. For your protection, telephone calls are usually recorded. BlackRock is a trading name of BlackRock Investment Management (UK) Limited.

For distribution in EMEA for Professional Investors only, or “professional clients”, as such term may apply in relevant jurisdictions. In Japan, not for use with individual investors. This material is being distributed/issued in Canada, Australia and New Zealand by BlackRock Financial Management, Inc. ("BFM"), which is registered as an International Advisor with the Ontario Securities Commission. In addition, BFM is a United States domiciled entity and is exempted under Australian CO 03/1100 from the requirement to hold an Australian Financial Services License and is regulated by the Securities and Exchange Commission under US laws which differ from Australian laws. In New Zealand, this presentation is offered to institutional and wholesale clients only. It does not constitute an offer of securities to the public in New Zealand for the purpose of New Zealand securities law. BFM believes that the information in this document is correct at the time of compilation, but no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BFM, its officers, employees or agents. This document contains general information only and is not intended to be relied upon as a forecast, research, investment advice, or a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The information does not take into account your financial circumstances. An assessment should be made as to whether the information is appropriate for you having regard to your objectives, financial situation and needs.

In a move that took many market commentators by surprise, the Governing Council of the European Central Bank (ECB) has voted to cut the benchmark interest rate by 0.25% to 1.25%.

  • The interest rate on the ECB’s deposit facility was also cut by 25 basis points to 0.5%, while the rate on the marginal lending facility was reduced by the same amount, from 2.25% to 2.0%. 
  • This was the first Governing Council meeting presided over by Mario Draghi, former governor of the Italian central bank, who replaced Jean-Claude Trichet as President at the start of November. Draghi’s tenure has begun at a time of great pressure on the ECB. Events relating to the peripheral debt crisis have caused extreme market volatility in recent days and raised fears about the ability of Greece to avoid a hard default and about the fiscal position of other eurozone states, particularly Italy.
  • In the press conference, Draghi noted that the region could experience a mild recession, which would put downward pressure on inflation. In contrast, upward pressure on inflation could come from increases in indirect taxes and administered prices.
  • In the question and answer session following the initial statement, many of the questions focused on the Securities Markets Programme (SMP), the ECB’s bond purchase facility. Draghi emphasised that the three key characteristics of the SMP are that it is temporary, limited in size and justified by the need to restore functioning monetary policy transmission mechanisms.
  • Interestingly, Draghi responded to a question about whether the ECB would explicitly become the lender of last resort to sovereigns within the eurozone with his own question – why do people think this is necessary to ensure the survival of the single currency bloc?
  • On the widening of Italian government bond yields over Germany, Draghi noted that for a long period of time spreads within the eurozone had been extremely narrow and hadn’t fully reflected the true differences in underlying macroeconomic fundamentals. He commented that now some spreads had overshot but that the ECB could not be expected to permanently reduce bond yields, rather, they should reflect fundamentals.
  • Draghi called for an acceleration in the structural reforms of debt-laden member states and commented that all countries needed to demonstrate an “inflexible determination” to the fiscal commitments that they have made.

Background – Deteriorating Economic Data 

  • The flash estimate for annual HICP inflation registered 3.0% in September and October, a three-year high[1]. Inflation has now remained above the ECB’s target of “close to but below 2%” for some time.
  • Since the last monetary policy announcement in October, economic data releases have continued to suggest a significant moderation in economic growth across the eurozone.
  • Purchasing Managers’ Index (PMI) data have continued to disappoint. The manufacturing and services PMIs both fell further below the important 50-level in October[2]. A figure below 50 is generally viewed as signalling contraction. The final manufacturing PMI registered 47.1, down from 48.5 in September, while the flash services PMI fell to 47.2 in October, down from 48.8. The composite index recorded 47.2 in October, down from 49.1.
  • According to the accompanying report by Markit: “The latest manufacturing PMI further emphasises the marked reversal of fortunes for a sector that was the leading light of the economic recovery. Output, new orders and new export orders all suffered their fastest declines since mid-2009, against a backdrop of weak domestic market conditions, the ongoing debt crisis and a darkening outlook for the global economy.”
  • The results of the European Commission (EC)’s survey for October reinforced the message of weakening growth. Eurozone economic sentiment declined slightly in October to 94.8, after a sharp drop of 3.4 points the previous month. Consumer confidence also continued its descent in October, to -19.9, down from -19.1 in September.
  • In Germany, the IFO survey remained on a downward trajectory in October, with the headline reading falling to 106.4, from 107.5 in September. The expectations component is significantly weaker than the current conditions component.
  • The region’s unemployment rate deteriorated in September to 10.2%, while the rate for August was also revised up to 10.1% from 10.0%[3]. Spain continued to have the highest unemployment rate, at 22.6%, followed by Greece (at 17.6% in July), while the lowest remained Austria, at 3.9%. Eurozone youth unemployment (under 25 years old) increased to 21.2% in September, from 20.4% in August. The youth unemployment rate in Spain and Greece reached a worrying 48.0% and 43.5% respectively in September.
  • The ECB will update its staff projections for economic growth and inflation in December.

The Sovereign Debt Crisis

  • The initial market reaction to the agreement struck by the leaders of the 17 eurozone member states at the summit meeting last Wednesday was a sharp rally in all risk markets. However, European stocks (and banks in particular) fell sharply on Tuesday after Greek Prime Minister George Papandreou’s surprise announcement that he will put the latest bailout deal to a referendum – the nation’s first referendum since 1974. Today (3 November), in a potentially dramatic U-turn, the referendum looks likely to be scrapped.
  • The agreement reached at the summit covered several main topics: enhancing the European Financial Stability Facility (EFSF), agreement on burden sharing and support for Greece, recapitalisation of European banks, further austerity pledges from Spain and Italy and broad changes to the governance of the eurozone. Although fairly wide reaching, the announcements thus far have been relatively light on specifics. (For more details please see the ‘Bullet on the Eurozone Summit’ dated Thursday 27 October).
  • In a positive sign for the unsecured bond market, which was virtually shut in August and September, Banco Bilbao Vizcaya Argentaria (BBVA), Spain’s second-largest lender, last week issued the first unsecured bond by a peripheral eurozone bank since June.
  • US broker-dealer, MF Global Holdings, filed for Chapter 11 bankruptcy on Monday after several ratings agencies downgraded the company to ‘junk’ status due to its significant exposure to peripheral eurozone debt.

Comments from Scott Thiel, Deputy Chief Investment Officer of Fundamental Fixed Income: 

  • The rate cut by the ECB was certainly a surprise – both to us and to the market. At the October press conference, President Trichet did not signal, through “ECB speak”, a rate cut for this month. In addition, market consensus believed that at his inaugural meeting, President Draghi would be conservative and continue to pressure peripheral governments on austerity by maintaining financing rates at 1.5%.
  • We agree with the ECB’s rationale in cutting rates – slowing economic activity is likely to lead to moderation of inflation expectations. The timing of the cut shows that the ECB is now willing to be bolder. We also hope that this in turn means that the ECB is willing to be intellectually flexible. It is through this flexibility that the ECB can become more of a force in solving the EMU debt crisis.

1. Eurostat 31 October 2011
2. Markit 2 November 2011
3. Eurostat 31 October 2011

All other data source: BlackRock DataStream November 2011

This material is for distribution to Professional Clients and should not be relied upon by any other persons. Research in this document has been produced and may been acted on by BlackRock for its own purposes. The views expressed do not constitute investment advice and are subject to change. All financial investments involve an element of risk. Therefore, the value of your investment and the income from it will vary and your initial investment amount cannot be guaranteed. Past performance is not a guide to future performance and should not be the sole factor of consideration when selecting a product. Issued by BlackRock Investment Management (UK) Limited (authorised and regulated by the Financial Services Authority). Registered office: 12 Throgmorton Avenue, London, EC2N 2DL. Registered in England No. 2020394. Tel: 020 7743 3000. For your protection, telephone calls are usually recorded. BlackRock is a trading name of BlackRock Investment Management (UK) Limited. For distribution in EMEA for Professional Investors only, or “professional clients”, as such term may apply in relevant jurisdictions. In Japan, not for use with individual investors. This material is being distributed/issued in Canada, Australia and New Zealand by BlackRock Financial Management, Inc. ("BFM"), which is registered as an International Advisor with the Ontario Securities Commission. In addition, BFM is a United States domiciled entity and is exempted under Australian CO 03/1100 from the requirement to hold an Australian Financial Services License and is regulated by the Securities and Exchange Commission under US laws which differ from Australian laws. In New Zealand, this presentation is offered to institutional and wholesale clients only. It does not constitute an offer of securities to the public in New Zealand for the purpose of New Zealand securities law. BFM believes that the information in this document is correct at the time of compilation, but no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BFM, its officers, employees or agents. This document contains general information only and is not intended to be relied upon as a forecast, research, investment advice, or a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The information does not take into account your financial circumstances. An assessment should be made as to whether the information is appropriate for you having regard to your objectives, financial situation and needs.

As has been well-publicised this morning, the latest measures to deal with the sovereign debt crisis in Europe centre on a three-point plan to prevent a ‘melt-down’ scenario in Europe.

  • These measures include a voluntary 50% reduction of the face value of Greek sovereign debt, a re-capitalisation on banks in Europe to a minimum core tier one equity ratio of 9% (under ‘Basel 2.5’ assumptions) and leveraging the European Financial Stability Facility (EFSF) to support €1 trillion of primary sovereign debt issuance in the eurozone. The announcements also include a government guarantee of bank funding to prevent a drying up of liquidity in the eurozone under times of stress.
  • The full details of these announcements are yet to be released, but so far the news has been taken positively by the European equity markets, with many indices up more than 4% at the time of writing. Italian sovereign yields have also declined this morning, supported by direct intervention from the European Central Bank (ECB) as part of its program to buy limited amounts of distressed sovereign debt in the secondary market. 
  •  In our view, these announcements do go some way to preventing a ‘meltdown’ scenario in Europe, but they fall well short of a ‘grand solution’ to the problems faced by both European governments and the European banking system. Whilst a step in the right direction, the proposed haircut on Greek sovereign debt does not solve the long-term indebtedness of the sovereign and the recapitalisation plan for the banking system does not prevent structural deleveraging from impacting on the profitability of the sector. In addition, we do not as yet have details on how the EFSF would be leveraged and we remain concerned about the degree to which this vehicle can be used to backstop sovereign yields, especially given that the AAA credit rating of France, one of the biggest contributors to the EFSF, is currently under threat.
  • A lot of questions remain to be answered and as such we see this morning’s reaction in the markets as a short-term relief rally. We reiterate the point that markets have risen more than 15% from the lows at the beginning of the month and, whilst many market participants are defensively positioned, the corporate earnings outlook is deteriorating fast, as reflected in a thus-far disappointing Q3 earnings season for Europe.
  • On a more positive note, European equities are currently trading at historically low valuations, especially when compared with the US equity market, and there is potential for global asset allocators to be a net buyer of European equities at the margin as the risk premium for ‘meltdown’ in Europe is removed. 
  •  As mentioned, third quarter European company earnings have so far underperformed expectations. We remain vigilant, aiming to avoid companies that we expect to disappoint. Whilst last night’s announcements are a step in the right direction, we believe that there is a long way to go before the sovereign debt crisis in Europe is finally resolved.

All data sourced by BlackRock Datastream as at 27 October 2011. This material is for distribution to Professional Clients and should not be relied upon by any other persons. Research in this document has been produced and may been acted on by BlackRock for its own purposes. The views expressed do not constitute investment advice and are subject to change. All financial investments involve an element of risk. Therefore, the value of your investment and the income from it will vary and your initial investment amount cannot be guaranteed. Past performance is not a guide to future performance and should not be the sole factor of consideration when selecting a product. Issued by BlackRock Investment Management (UK) Limited (authorised and regulated by the Financial Services Authority). Registered office: 12 Throgmorton Avenue, London, EC2N 2DL. Registered in England No. 2020394. Tel: 020 7743 3000. For your protection, telephone calls are usually recorded. BlackRock is a trading name of BlackRock Investment Management (UK) Limited. For distribution in EMEA for Professional Investors only, or (“professional clients”, as such term may apply in relevant jurisdictions). In Japan, not for use with individual investors. This material is being distributed/issued in Canada, Australia and New Zealand by BlackRock Financial Management, Inc. ("BFM"), which is registered as an International Advisor with the Ontario Securities Commission. In addition, BFM is a United States domiciled entity and is exempted under Australian CO 03/1100 from the requirement to hold an Australian Financial Services License and is regulated by the Securities and Exchange Commission under US laws which differ from Australian laws. In New Zealand, this presentation is offered to institutional and wholesale clients only. It does not constitute an offer of securities to the public in New Zealand for the purpose of New Zealand securities law. BFM believes that the information in this document is correct at the time of compilation, but no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BFM, its officers, employees or agents. This document contains general information only and is not intended to be relied upon as a forecast, research, investment advice, or a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The information does not take into account your financial circumstances. An assessment should be made as to whether the information is appropriate for you having regard to your objectives, financial situation and needs.

Leaders of the 17 eurozone member states met yesterday evening to discuss a response to the sovereign debt crisis. The following is based on comments from Scott Thiel, Deputy Chief Investment Officer of Fundamental Fixed Income. 

  • The subsequent announcements covered several main topics: enhancing the European Financial Stability Facility (EFSF), agreement on burden sharing and support for Greece, recapitalisation of European banks, further austerity pledges from Spain and Italy and broad changes to the governance of the Eurozone. Although fairly wide reaching, the announcements thus far have been relatively light on specifics.
  • The initial market reaction has been very positive for risk assets and negative for risk free interest rates. Of particular note, the rally in synthetic contracts (such as credit default swaps) has outpaced physical assets.

Enhancing the EFSF

  • Two options were announced for the EFSF to increase its “firepower”. The terms and conditions are to be finalised in November, on the basis of work carried out by the Eurogroup working group, the EFSF and the European Commission (EC). Once the details have been finalised, implementation by the EFSF could take several weeks.
  • Option 1: Credit enhancement of sovereign primary issuance. A sovereign bond with partial protection which would be funded by the EFSF.
  • Option 2: Generator of new funding sources. A special purpose vehicle (SPV) to be created centrally or in the beneficiary member state, combining public and private capital and funding for extending loans for bank recapitalisations via a member state and/or buying bonds in the primary and secondary market, EFSF provides the equity & takes first loss.

Agreement on Greece

  • The sixth tranche of funds is to be disbursed and a new adjustment programme is being negotiated to cover Greece’s financing needs up to 2014. Furthermore, policymakers decided to increase the level of private sector involvement (PSI) in the Greek bailout package. Outside the actual announcement, reports are circulating of a 50% cut in the face value of bonds, which is believed would reduce the projected peak of the debt-to-GDP ratio to 120%.

European Bank Recapitalisation 

  • A two-step plan was announced regarding the recapitalisation of European banks. They will be required to raise their tier 1 capital ratios to 9% by June 2012 (based on the market valuation of assets as of 30 September 2011). The recapitalisation plan will be via private investor funding sources first, then through national government support and finally with EFSF support.

Spain and Italy

  • The EU praised steps “taken” by Spain and Italian “plans” to address fiscal consolidation – attempting to both highlight actions taken in Spain and to pressure both Spain and Italy to continue to improve fundamentals.

Eurozone Governance

  • A number of changes to the governance of the eurozone were announced. The most significant included: a decision for the Euro Summit (leaders of the eurozone member states, the President of the EC and the President of the Euro Summit) to meet at least twice a year; the President of the Euro Summit will keep non-eurozone member states closely informed of preparations and outcomes of summits; the Eurogroup will prepare the Euro Summit and ensure follow up; and the President of the Euro Summit will meet regularly (at least once a month) with the President of the EC and the President of the Eurogroup, while the presidents of the European Central Bank, the supervisory authorities and others may also be invited.

This material is for distribution to Professional Clients and should not be relied upon by any other persons. Research in this document has been produced and may been acted on by BlackRock for its own purposes. The views expressed do not constitute investment advice and are subject to change. All financial investments involve an element of risk. Therefore, the value of your investment and the income from it will vary and your initial investment amount cannot be guaranteed. Past performance is not a guide to future performance and should not be the sole factor of consideration when selecting a product. Issued by BlackRock Investment Management (UK) Limited (authorised and regulated by the Financial Services Authority). Registered office: 12 Throgmorton Avenue, London, EC2N 2DL. Registered in England No. 2020394. Tel: 020 7743 3000. For your protection, telephone calls are usually recorded. BlackRock is a trading name of BlackRock Investment Management (UK) Limited. For distribution in EMEA for Professional Investors only, or (“professional clients”, as such term may apply in relevant jurisdictions). In Japan, not for use with individual investors. This material is being distributed/issued in Canada, Australia and New Zealand by BlackRock Financial Management, Inc. ("BFM"), which is registered as an International Advisor with the Ontario Securities Commission. In addition, BFM is a United States domiciled entity and is exempted under Australian CO 03/1100 from the requirement to hold an Australian Financial Services License and is regulated by the Securities and Exchange Commission under US laws which differ from Australian laws. In New Zealand, this presentation is offered to institutional and wholesale clients only. It does not constitute an offer of securities to the public in New Zealand for the purpose of New Zealand securities law. BFM believes that the information in this document is correct at the time of compilation, but no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BFM, its officers, employees or agents. This document contains general information only and is not intended to be relied upon as a forecast, research, investment advice, or a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The information does not take into account your financial circumstances. An assessment should be made as to whether the information is appropriate for you having regard to your objectives, financial situation and needs.

As we had expected, the Governing Council of the European Central Bank (ECB) have voted to keep the benchmark interest rate unchanged at 1.5%. The ECB did, however, announce a number of additional financing measures to provide further liquidity to the eurozone.

  • Jean-Claude Trichet, the outgoing president of the ECB, announced a new covered bond purchase programme worth about €40bn.
  • The ECB are also introducing two longer-term, fixed-rate, full allotment financing operations - one for 12 months from October and another for 13 months from December (this carrying over year-end 2012).
  • They are also continuing the full allotment of the monthly refinancing operations (MROs) until the end of the July 2012 maintenance period.
  • The ECB will be conducting three-month, fixed-rate, long-term refinancing operations from January through June 2012.
  • The meeting today was conducted in Berlin and was the final ECB meeting with Jean-Claude Trichet as president. His eight-year term finishes at the end of October, when he will be replaced by the governor of the Italian central bank, Mario Draghi.

Background – deteriorating economic data

  • The flash estimate for annual HICP inflation increased in September to a three-year high of 3.0%, up from 2.5% in August. Inflation has now remained above the ECB’s target of “close to but below 2%” for some time[1].
  • Since the last monetary policy announcement in September, economic data releases have continued to suggest a significant moderation in economic growth across the eurozone.
  • Purchasing Managers’ Index (PMI) data has continued to disappoint, with the manufacturing PMI for the region as a whole hitting a 25-month low in September[2] at 48.5, down from 49.0 in August. A number below 50 is generally viewed as signalling contraction. Among the components, new orders fell at the fastest rate for over two years. By country, the German manufacturing PMI fell to a 24-month low, at 50.3, while the indices for France, Italy, the Netherlands, Spain and Ireland were all below the 50-level. Spain hit a 27-month low at 43.7, while the Italian PMI actually increased to 48.3.
  • According to the accompanying report by Markit, “manufacturers are reporting the worst business conditions for over two years, facing a combination of lacklustre domestic demand and falling export sales. Output fell only modestly in September, but a faster rate of decline in new orders suggests that the number of manufacturers cutting production is likely to increase as we move into the fourth quarter.”
  • The results of the European Commission (EC)’s survey for September reinforced the message of weakening growth. Eurozone economic sentiment dropped sharply in September to 95.0, from 98.4 in August. Furthermore, there were declines across all countries including Germany, albeit at a higher absolute level. It appears that the weakening global economy and recent amplification of the sovereign debt crisis are taking their toll on economic sentiment across the region.
  • Not surprisingly, consumer confidence declined in September, to -18.9, down from -16.5 in August. The decline was broad-based by sector and country, with a large increase in unemployment concerns. In Germany, the IFO survey remained on a downward trajectory in September, with the headline reading falling to 107.5, from 108.7 in August. The drop was largely caused by deterioration in the expectations component although current conditions also fell slightly.
  • The region’s unemployment rate remained stable in August at 10.0%[3]. Spain continued to have the highest unemployment rate, at 21.2%, followed by Greece with 16.7%, while the lowest remained Austria, at 3.7%. Eurozone youth unemployment averaged 20.4% in August.

The sovereign debt crisis

  • The sovereign debt crisis has intensified in recent weeks, with substantial risks surrounding the near-term outlook for Greece. The disbursement of the next tranche of the Greek bailout package has been pushed back, pending the outcome of the review currently being undertaken by the EU/IMF/ECB troika. Eurogroup chairman Jean-Claude Juncker has indicated that no decision on the release of the funds is likely until November.
  • Moody’s downgraded Italy’s long-term credit rating on Tuesday by three notches, to A2 (from Aa2), with a negative outlook. Although the size of the downgrade was a surprise it is in line with S&P’s A rating, although Fitch still rates Italian debt higher at AA-. Attention is now likely to focus on the credit ratings of Spain and France.
  • This week Franco-Belgian bank Dexia admitted that it had requested government support. Already bailed out in 2008, there has been intense market pressure on the bank due to its exposure to Greek and Italian debt and an increasing reliance on short-term funding. France and Belgium have both affirmed that they will take steps to prevent Dexia from collapsing.
  • There has been increasing commentary in the media about recapitalising Europe’s ailing banks. German finance minister Wolfgang Schäuble has said that Berlin could potentially reactivate bank support mechanisms that had been put in place in 2008 but had subsequently expired. Meanwhile, the EC’s commissioner for economic affairs, Olli Rehn, stated on Tuesday that the capital positions of European banks must be reinforced.
  • The spreads on credit default swaps (CDS), which are a form of insurance against bond defaults and are viewed by some as a gauge of the market’s assessment of default risk for banks, are highlighting significant amounts of distress in the system.
  • Most countries have now ratified the agreement reached in July to extend the powers of the European Financial Stability Facility (EFSF), including Germany. Under the new proposal, the size of the EFSF will be increased to EUR 440bn, although after taking into account some collateral and existing commitments to Greece, the EFSF will have around EUR 250bn of new capital to employ. Slovakia is due to vote on the proposal on 11 October.  

Comments from Scott Thiel, Deputy Chief Investment Officer of Fundamental Fixed Income:

  • As we had expected, the ECB did not cut the repo rate or the corridor.  Interestingly, the ECB was vague on whether the market should expect a repo rate cut next month – perhaps to relieve any pressure on Draghi’s first meeting as the new Governing Council President.
  • Also as generally expected, the ECB did offer longer-term refinancing facilities,  for 12 and 13 months respectively, and officially announced the covered bond purchase programme. We were slightly surprised that they did offer a two-year financing facility.
  • With the current valuations of risk-free assets, we are more focused on the paramount question of how to solve the broader strain in the European financial and sovereign bond markets. 


1. Eurostat 30 September 2011
2. Markit 3 October 2011
3. Eurostat 30 September 2011
All other data source: BlackRock DataStream October 2011


This material is for distribution to Professional Clients and should not be relied upon by any other persons. Research in this document has been produced and may been acted on by BlackRock for its own purposes. The views expressed do not constitute investment advice and are subject to change. All financial investments involve an element of risk. Therefore, the value of your investment and the income from it will vary and your initial investment amount cannot be guaranteed. Past performance is not a guide to future performance and should not be the sole factor of consideration when selecting a product. Issued by BlackRock Investment Management (UK) Limited (authorised and regulated by the Financial Services Authority). Registered office: 12 Throgmorton Avenue, London, EC2N 2DL. Registered in England No. 2020394. Tel: 020 7743 3000. For your protection, telephone calls are usually recorded. BlackRock is a trading name of BlackRock Investment Management (UK) Limited.

For distribution in EMEA for Professional Investors only, or (“professional clients”, as such term may apply in relevant jurisdictions). In Japan, not for use with individual investors. This material is being distributed/issued in Canada, Australia and New Zealand by BlackRock Financial Management, Inc. ("BFM"), which is registered as an International Advisor with the Ontario Securities Commission. In addition, BFM is a United States domiciled entity and is exempted under Australian CO 03/1100 from the requirement to hold an Australian Financial Services License and is regulated by the Securities and Exchange Commission under US laws which differ from Australian laws. In New Zealand, this presentation is offered to institutional and wholesale clients only. It does not constitute an offer of securities to the public in New Zealand for the purpose of New Zealand securities law. BFM believes that the information in this document is correct at the time of compilation, but no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BFM, its officers, employees or agents. This document contains general information only and is not intended to be relied upon as a forecast, research, investment advice, or a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The information does not take into account your financial circumstances. An assessment should be made as to whether the information is appropriate for you having regard to your objectives, financial situation and needs.

The Bank of England’s Monetary Policy Committee (MPC) has opted to keep base rates at 0.5% but has increased its asset purchase programme (quantitative easing) by £75bn to £275bn.

  • The MPC decided to restart its asset purchase programme in a bid to stimulate the economy. UK domestic growth has continued to exhibit risks to the downside, demonstrating that it is far from immune from the deficit crises in the eurozone and the US.
  • Market consensus continues to price any increase in interest rates over 12 months away (February 2013). Against this backdrop, we do not expect any change in the near term, with rates on hold for the foreseeable future. 

Background

  • In its latest Quarterly Bulletin[1], the Bank of England (BoE) suggested that its £200bn QE programme has probably boosted real GDP by 1.5-2% so far, the equivalent of a 150-300bp cut in Bank rate, and increased inflation by 0.75-1.5%.
  • Economic growth for the second quarter has been revised down by the Office for National Statistics (ONS) to 0.1% q/q[2], from the original 0.2% estimate. In September, the International Monetary Fund (IMF) cut its UK growth forecast. It now estimates that growth this year will be 1.1%, down from 1.5% in June, and cut the outlook for 2012 down to 1.6%, from 2.3%.
  • The minutes from the September MPC meeting showed a unanimous decision to maintain base rates at 0.5%. Adam Posen was, yet again, alone in voting for an additional £50 billion of QE[3]. However, the minutes stated that “for most members, the decision of whether to embark on further monetary policy easing at this meeting was finely balanced” and the inflation risks “have shifted further to the downside”.
  • Both David Miles and Ben Broadbent have subsequently commented that their votes were a close call. Meanwhile, Chief Economist of the BoE, Spencer Dale, said[4] “the outlook for demand over the past few months has weakened… Growth in the world economy, including in our core trading partners in Europe and the US, has slowed. Concerns about the fiscal positions of some countries, particularly within the euro area, have intensified. This in turn has fuelled worries and uncertainties about the resilience of the international banking system. And perhaps most fundamentally of all, confidence that the authorities have the ability to respond to these challenges in a decisive and timely manner has diminished.”
  • Adam Posen has suggested creating a public bank to provide small and medium-sized enterprises (SMEs) with loans and another entity to securitise bundles of SME loans[5]. He has estimated that the investment gap caused by a lack of lending is around 2-3% of GDP.
  • CPI inflation remains significantly above the Bank’s 2% target and rose again in August, to 4.5% y/y, from 4.4% in July[6]. Fuel and transport prices remained large contributors to the inflation rate. Meanwhile, the Citi/YouGov poll showed that inflation expectations for the year ahead remained unchanged in September at 3.5%[7], while expectations for the longer term (5-10years) increased slightly to 3.8% y/y (from 3.7%).
  • Recent economic data has been generally weak. The Confederation of British Industry’s survey of manufacturing firms reported declines in output expectations and export orders. The volume of retail sales excluding auto fuels declined by 0.1% m/m in August[8] (and also contracted by 0.1% y/y), after 0.2% growth in July. However, the data was slightly better than consensus expectations.
  • Purchasing managers’ index (PMI) data for September[9] exceeded consensus expectations. The manufacturing index rose to 51.1, from 49.4 in August, taking it above the important 50-level and marking the first increase since January. The output and new orders components both rose above 50, while employment increased to 49.6. A figure above 50 usually suggests expansion. The services PMI also beat expectations, rising to 52.9 in September from 51.1 in August.
  • In the housing market, the RICS Housing Market Survey price balance declined to -23 in August, from -22 in July, signifying that more surveyors reported price declines than increases. The average number of sales per surveyor also hit a 26-month low in August. In contrast, the Nationwide house price index grew 0.1% m/m in September, after declining by 0.6% in August.
  • Data released in September showed that the unemployment rate remained unchanged at 7.9%, although there was a rise in the number of people claiming Jobseeker’s Allowance[10]. The GFK consumer confidence survey improved slightly in September, increasing to -30 from -31 in August.
  • On Monday Chancellor of the Exchequer George Osborne raised the prospect of the government introducing measures designed to improve the supply of credit to smaller firms in some form of credit easing. 

Comments from BlackRock’s Sterling Fixed Income team:  
 

  • The European crisis continues to reverberate, with markets remaining volatile as European leaders struggle to find a cohesive plan of action. The prospect that China would be a “white knight” by buying large amounts of eurozone debt seems to have disappeared with increased negative sentiment in the emerging markets space.
  • In the UK, the search for a "game changer" on growth continues, with the private sector seemingly unable to kick start the economy. We have seen further weak data this month, with a fall in UK retail sales and rising public sector unemployment but also an upside shock on the PMI, expanding for the first time in three months. The risk of a sustained low growth environment has definitely increased but a return to recession is not our base case scenario.
  • Given this, we remain aligned with market consensus and believe that official interest rates in the UK will stay ‘lower for longer’.
  • The gilt market is likely to remain a hostage to global economic developments in the months ahead and growth prospects, inflation and progress on the government deficit will be pivotal for the market. Yields continue to set record lows, as investors seek shelter in government bonds. We remain relatively cautious in our positioning as a result of increased levels of volatility in the macro environment and the dearth of liquidity.
  • For corporate bonds the environment continues to be challenging. Credit spreads (the additional yield above gilts) increased significantly during the third quarter, as government bonds substantially outperformed corporate bonds for the three months ending September. Spreads in some financial sectors are back to levels last seen during the crisis in 2009 and returns on corporate bonds are now negative year-to-date.
  •  The market perceives that governments in Europe and the US have not done enough to ensure the foundation of the sovereign and financial sectors. As a result, the corporate financial sector continues to bear the brunt, in particular the banking sub sector where a lot of peripheral government bond exposure is held. 
  • Positioning within the BlackRock Corporate Bond Fund remains defensive with the addition of cash generating sectors. We continue to add new issuance from telecommunications and non-cyclical issuers based on attractive relative valuations. 
  • We believe the market has under-priced some core sectors where balance sheets remain strong and capital structure robust. We maintain our long-held overweight to financials and still believe this is best expressed in the insurance sector where volatility, regulatory risk and potential supply are all significantly lower. Within non-financials, corporate balance sheets remain healthy and global default rates remain very low and we believe that carefully selected holdings in this sector will weather the storm. If anything, these market setbacks provide opportunities to increase exposure, however, we want to be sure of greater stability in the macro environment ahead of adding to our holdings.
  • Exposure to US and European government bonds has long been a diversifying position for the fund and has allowed us some protection against recent negative performance from the corporate bond sector.
  • We continue to make use of tactical derivative strategies, such as credit default swaps, to protect the portfolio from negative market movements.
  • We remain focused on selecting the best names for the portfolio and believe that this will enable the fund to continue performing well over the long term. We believe that fixed income forms a key part of any well-constructed, diversified portfolio and that, while volatility has increased, active management of corporate bonds is the right approach. We believe that credit spreads will be tighter in 12-18 months from now.


1. Bank of England, Quarterly Bulletin Q3 2011, 19 September 2011
2. ONS 5 October 2011
3. Bank of England, September 2011
4. 21 September Tyneside
5. 13 September, Gloucestershire
6. ONS September 2011
7. YouGov September 2011
8. ONS September 2011
9. Markit October 2011
10. ILO September 2011
All other data source: BlackRock DataStream October 2011

Issued by BlackRock Investment Management (UK) Limited, authorised and regulated by the Financial Services Authority.  Registered office: 12 Throgmorton Avenue, London, EC2N 2DL. Tel: 020 7743 3000. Registered in England No. 2020394. For your protection telephone calls are usually recorded. BlackRock is a trading name of BlackRock Investment Management (UK) Limited.

Past performance is not a guide to future performance. The value of investments and the income from them can fall as well as rise and is not guaranteed. You may not get back the amount originally invested. Changes in the rates of exchange between currencies may cause the value of investments to diminish or increase. Fluctuation may be particularly marked in the case of a higher volatility fund and the value of an investment may fall suddenly and substantially. Levels and basis of taxation may change from time to time.

BlackRock Corporate Bond Fund invests a large portion of assets which are denominated in other currencies; hence changes in the relevant exchange rate will affect the value of the investment. Some or all of the Manager’s annual charge for the Fund is taken from capital rather than from income. Whilst this increases the yield, it reduces the potential for capital growth. The fund invests in high yielding bonds. Companies who issue higher yield bonds typically have an increased risk of defaulting on repayments. In the event of default, the value of your investment may reduce. Economic conditions and interest rate levels may also impact significantly the values of high yield bonds. The fund invests in fixed interest securities such as corporate or government bonds which pay a fixed or variable rate of interest (also known as the ‘coupon’) and behave similarly to a loan. These securities are therefore exposed to changes in interest rates which will affect the value of any securities held. The Distribution Yield provides an indication of income payable by the Fund over the next 12 months based on the portfolio as at the date of calculation. The Underlying Yield reflects the annualised income net of expenses calculated in accordance with relevant accounting standards. Where the Fund elects to distribute income on a coupon basis rather than in accordance with these accounting methods, the Distribution Yield will differ from the Underlying Yield. Similarly, if some or all of the Fund's expenses are charged to capital, the Distribution Yield will be higher than the Underlying Yield but this may reduce the potential for capital growth. The published figures do not reflect any initial charges nor the impact of tax which may be incurred by an investor.

Any research in this document has been procured and may have been acted on by BlackRock for its own purpose. The results of such research are being made available only incidentally. The views expressed do not constitute investment or any other advice and are subject to change. They do not necessarily reflect the views of any company in the BlackRock Group or any part thereof and no assurances are made as to their accuracy.

This document is for information purposes only and does not constitute an offer or invitation to anyone to invest in any BlackRock funds and has not been prepared in connection with any such offer.

This material is for distribution to Professional Clients (as defined by the FSA Rules) and should not be relied upon by any other persons.

A variety of developments over the past few days have caused high levels of volatility in financial markets, with conditions within the eurozone generally worsening.

Over the past couple of weeks bund yields hit new lows and the euro depreciated sharply, until the announcement yesterday of coordinated action by five central banks to provide US dollar liquidity caused stock markets to rally and the euro to appreciate against the dollar.

Eurozone sovereign debt crisis

  • Jürgen Stark, the European Central Bank (ECB)’s Chief Economist, announced on Friday that he will step down early. Although his tenure was due to expire in 2014, Stark apparently disagrees with the ECB's Securities Markets Programme (SMP). In August the ECB resumed the purchase of government bonds through the SMP, which is essentially a de facto monetisation of peripheral debt. The ECB has effectively become a lender of last resort for governments as well as banks and, by monetising the sovereign debt problem, risks undermining confidence in the currency.
  • This week Bundesbank President and ECB board member Jens Weidmann commented that people within the eurozone are worried about their currency and reiterated his criticism of the bond purchases[1], saying that the ECB has burdened itself with considerable risks. At the start of September[2] Weidmann stated that the ECB’s bond purchases have "strained the existing framework of the currency union and blurred the boundaries between monetary policy and fiscal policy.”
  • President of the European Commission (EC) Jose Manuel Barroso said this week that he is close to proposing options for a joint euro bond, however, Germany remains firmly opposed to the notion.
  • Rather, last week German Chancellor Angela Merkel proposed a new European Union Treaty that would permit a common economic policy. As well as deeper integration, she also called for better adherence to the rules[3].
  • In a joint statement released after their conference call with Greek Prime Minister Papandreou last night, Merkel and French PM Sarkozy stated that they are happy with Greece’s progress and that it will remain in the euro. Yesterday’s Spanish bond auction also went relatively smoothly, selling EUR 3.95bn with a maximum target of EUR 4bn.
  • Last week the ECB kept interest rates on hold, however, the likelihood of the next move being a reversal of the July rate increase, as early as November, have risen significantly. The ECB staff forecasts for eurozone GDP growth were also revised down to a range of 1.4-1.8% for 2011 and to 0.4-2.2% for 2012.
  • Yesterday the ECB, US Federal Reserve, Bank of England, Bank of Japan (BoJ) and Swiss National Bank (SNB) announced a coordinated move to provide additional US dollar liquidity to the banking system, in three tranches with a three-month maturity.
  • Separately, Christine Lagarde, Head of the International Monetary Fund, said yesterday: “There is still too much debt in the system. Uncertainty hovers over sovereigns across the advanced economies, banks in Europe, and households in the United States. Weak growth and weak balance sheets—of governments, financial institutions, and households—are feeding negatively on each other, fueling a crisis of confidence and holding back demand, investment, and job creation. This vicious cycle is gaining momentum and, frankly, it has been exacerbated by policy indecision and political dysfunction."[4]

Credit rating movements

  • This week Moody’s cut the long-term debt rating of two large French banks by one notch each, Credit Agricole and Societe Generale, on concerns over their exposure to Greek debt and potential funding difficulties.
  • Meanwhile, regarding Spain, Fitch has stated that the risks for the country’s credit rating are “clearly on the downside”. Data released last week showed that most regions are behind schedule to meet deficit targets and Fitch has now downgraded the ratings of five Spanish regions, including Catalonia. Spain currently has an AA+ rating with negative outlook from Fitch.
  • Italy is currently under review for a possible downgrade by Moody’s, who presently rate it Aa2. The Italian government will hope that the successful passage of their contentious austerity budget on Wednesday will prevent the need for a downgrade.

Currency manipulation

  • The SNB announced on 6 September that they will maintain a minimum EUR/CHF exchange rate of 1.20 by purchasing unlimited quantities of foreign currency. The timing of the announcement was a surprise which, in conjunction with a large intervention in the FX spot market, caused EUR/CHF to increase sharply.
  • Philipp Hildebrand, Chairman of the SNB, stated that international developments have “resulted in a massive overvaluation of our national currency. Switzerland is a small and very open economy. Every second franc is earned abroad. A massive overvaluation carries the risk of a recession as well as deflationary developments. The Swiss National Bank is therefore aiming for a substantial and sustained weakening of the Swiss franc.”[5]
  • There has been no mention of the EUR/CHF floor being temporary. The policy also means that CHF is no longer a liquid hedge for the eurozone crisis. Since the announcement, demand for the Scandinavian currencies and JPY has increased.
  • The SNB has a mandate to maintain price stability. However, it can only control either the exchange rate or inflation, therefore, the cost of currency stability may be a rise in Swiss inflation.
  • The SNB’s action will provide some relief for CHF currency mortgage holders in Eastern Europe. The relentless rise of the CHF put pressure on households in Hungary, and to a lesser extent in Poland, which amassed a considerable amount of CHF debt in the years preceding the global financial crisis.
  • The real test of the SNB’s new regime will be in the coming months as the eurozone debt crisis develops. It is highly likely that the external environment that the SNB is trying to counter will not be helpful towards the SNB’s objective.
  • Currency intervention and manipulation is nothing new, it is common among many countries, including Japan, Korea and Russia, as well as many EM Asian economies that would like to keep their currencies undervalued for trade advantages.
  • EM FX reserves have continued to surge this year. For most, the ongoing accumulation of reserves (mainly USD assets) aims to control the pace of currency appreciation to protect export sectors.
  • China operates a managed exchange rate regime with a tight trading band around a daily USD/CNY fixing, within a +/- 0.5% band, which is allowing for a gradual appreciation.
  • Japan’s currency market intervention is conducted by the Ministry of Finance (MoF) and the BoJ. In Japan the MoF issues T-bills to raise JPY, which they then sell in the FX market, therefore, intervention leads to an increase in Japanese government debt.
  • In August the MoF also introduced a USD 100bn loan facility to cope with JPY appreciation, aimed at urging domestic firms to increase M&A activities with foreign firms, to secure energy resources and to help exports by SMEs.

Comments from Scott Thiel, Deputy Chief Investment Officer of Fundamental Fixed Income:

  • There is no question that the central banks' coordinated activity is a significantly positive development. Firstly, the facility offered dramatically alleviates pressure on US dollar funding for the European banks – pressure that was reaching critical levels, especially for French banks. Second, it underscores that global central banks are focused on the EMU and European banking crisis and are willing to work together to develop a solution.
  • However, at the same time, it does not address other critical aspects to the current crisis. Importantly, the facility further in fact solidifies the markets reliance on the ECB to support the European banking system and suggests continued lack of coordination or consensus among European politicians.
  • While there is no doubt that funding pressure for French banks was an important issue, investors are still awaiting a broader fundamental solution to the EMU crisis. As such, we expect sustained high levels of volatility to continue.
  • Regarding the intervention in the Swiss franc, government intervention has become a dominant factor in the current environment. The Swiss government's move is a policy tool and, as with any unanticipated intervention, it is very difficult to pre-position aggressively around it. In 'normal' circumstances we could look at fundamental as well as technical factors, including government intervention, to formulate investment views. The concern is that the Swiss intervention has been left open ended.

[1] Cologne, 13 September 2011
[2] Hannover, 2 September 2011
[3] Berlin, 9 September 2011
[4] Washington DC, 15 September 2011
[5] 6 September 2011

All other data source: BlackRock DataStream September 2011

This material is for distribution to Professional Clients and should not be relied upon by any other persons. Research in this document has been produced and may been acted on by BlackRock for its own purposes. The views expressed do not constitute investment advice and are subject to change. All financial investments involve an element of risk. Therefore, the value of your investment and the income from it will vary and your initial investment amount cannot be guaranteed. Past performance is not a guide to future performance and should not be the sole factor of consideration when selecting a product. Issued by BlackRock Investment Management (UK) Limited (authorised and regulated by the Financial Services Authority). Registered office: 12 Throgmorton Avenue, London, EC2N 2DL. Registered in England No. 2020394. Tel: 020 7743 3000. For your protection, telephone calls are usually recorded. BlackRock is a trading name of BlackRock Investment Management (UK) Limited.

For distribution in EMEA for Professional Investors only, or (“professional clients”, as such term may apply in relevant jurisdictions). In Japan, not for use with individual investors. This material is being distributed/issued in Canada, Australia and New Zealand by BlackRock Financial Management, Inc. ("BFM"), which is registered as an International Advisor with the Ontario Securities Commission. In addition, BFM is a United States domiciled entity and is exempted under Australian CO 03/1100 from the requirement to hold an Australian Financial Services License and is regulated by the Securities and Exchange Commission under US laws which differ from Australian laws. In New Zealand, this presentation is offered to institutional and wholesale clients only. It does not constitute an offer of securities to the public in New Zealand for the purpose of New Zealand securities law. BFM believes that the information in this document is correct at the time of compilation, but no warranty of accuracy or reliability is given and no responsibility arising in any other way for errors and omissions (including responsibility to any person by reason of negligence) is accepted by BFM, its officers, employees or agents. This document contains general information only and is not intended to be relied upon as a forecast, research, investment advice, or a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy. The information does not take into account your financial circumstances. An assessment should be made as to whether the information is appropriate for you having regard to your objectives, financial situation and needs.

Council members of the European Central Bank (ECB) have voted to keep the benchmark interest rate unchanged at 1.5%

  • Jean-Claude Trichet, President of the ECB, noted in the press conference that the decision to keep interest rates on hold was unanimous. He also stated that the ECB staff forecasts for GDP growth have been revised down to a range of 1.4-1.8% for 2011 and to 0.4-2.2% for 2012. The staff HICP inflation projections are for 2.5-2.7% for 2011 and 1.2-2.2% for 2012. Trichet also noted that while risks to economic growth are to the downside, given the current environment of a high level of uncertainty, the risks to inflation are now balanced.

Background – weakening economic data

  • Inflation has remained above the ECB’s target of “close to but below 2%” for some time and the flash estimate for HICP annual inflation in the eurozone was stable in August at 2.5%[1].
  • Since the last monetary policy announcement in August, economic data releases have continued to suggest a significant moderation in economic growth across the eurozone.
  • Purchasing Managers’ Index (PMI) data disappointed in August. The manufacturing PMI for the region as a whole fell to 49.0, from 50.4 in July - a number below 50 is generally viewed as signalling contraction. By country, the German manufacturing PMI dropped to 50.9, from 52.0, while the French and Italian PMIs both fell below the important 50-level to 49.1 and 47.0 respectively.
  • Meanwhile, the services PMI for August registered 51.5[2], slightly down from 51.6 in July and the second-lowest reading since September 2009. According to the accompanying report by Markit, “euro area service sector growth slid closer to stagnation in August. A stalling of manufacturing growth, biting austerity measures and worries about the region’s deepening financial crisis have all taken their toll on demand for services in the summer, and led to the largest drop in optimism about prospects for the year ahead since the immediate aftermath of the collapse of Lehmans”.
  • The results of the European Commission (EC)’s survey for August reinforced the message of weakening growth from the PMI data. Consumer confidence declined to -16.5 in August, from -11.2 in July, while economic sentiment fell to 98.3 from 103.2. By country, economic sentiment was stable in Italy and Spain and actually increased in Greece. However, it fell sharply in Germany, where the IFO survey also plunged in August with declines across all sectors (business climate, business expectations and current conditions).
  • The region’s unemployment rate was revised up for May, June and July to 10.0%[3]. Amongst the member states, Spain continued to have the highest unemployment rate, at 21.2%, while it remained lowest in Austria at 3.7%. 
  • Real GDP for the eurozone grew 0.2% q/q in Q2, following 0.8% growth in Q1, while the German economy grew 0.1% q/q, following revised down growth of 1.3% in Q1. 

The sovereign debt crisis

  • In August the ECB resumed the purchase of government bonds through the Securities Markets Programme and decided earlier this month to continue conducting its refinancing operations as fixed-rate tender procedures with full allotment, at least until mid-January 2012. In a speech on 29 August, Trichet stated: “The purchases made on the secondary market cannot be used to circumvent the fundamental principle of budgetary discipline. The Securities Markets Programme strictly aims at correcting malfunctioning of markets”.
  • Elevated borrowing from the ECB suggests concerns about access to financing, while increased overnight deposits placed with the central bank suggest that banks are more concerned about the return of their capital than the return on capital. German Bund yields have also hit extreme lows in the face of weakening economic data and the ongoing sovereign debt problems.
  • This is a key month for developments concerning the sovereign debt crisis. The private sector was invited to declare an interest in taking part in a debt exchange as part of the second Greek bailout package by tomorrow (9 September) – after that date a formal invitation to declare binding interest will issued. Official support in the next bailout package is based on an assumption that participation in the swap will reach 90%.
  • Furthermore, a press release issued on 2 September stated that the  EC, ECB and IMF team that had been reviewing the first bailout package in order to authorise the next tranche of funding left Greece temporarily to “allow the authorities to complete technical work, among other things, related to the 2012 budget and growth-enhancing structural reforms. The mission expects to return to Athens by mid-September”[4]. This statement raised concerns that the country may have missed the 7.4% of GDP deficit target for this year by some margin.
  • Meanwhile, although an agreement was reached in July to extend the powers of the European Financial Stability Facility (EFSF) to offer assistance to countries not currently in a formal programme and to buy bank debt, this requires formal approval by the member countries. This process will now begin and probably continue through October. 

Comments from Scott Thiel, Deputy Chief Investment Officer of Fundamental Fixed Income:

  • Although the growth forecast has been reduced and the risks to the outlook for inflation are now seen as balanced, the main refinancing rate was kept at 1.5% and the corridor was also maintained. (The interest rates on the marginal lending and deposit facilities were held at 2.25% and 0.75% respectively). Judging by the language used in the press conference, we view the next change in monetary policy as most likely being a cut in interest rates in November.
  • President Trichet commented that there is no liquidity issue in the banking sector. In our view, that comment understates the stresses in the banking system and we note that the European fixed income market is effectively closed outside of risk-free assets.
  • Trichet’s response when questioned about the prospect of countries leaving the single currency was interesting, in that he simply asserted that all countries must fully respect the commitments that they had undertaken.
  • When questioned on the intervention of the Swiss National Bank (SNB) in currency markets (to no longer tolerate a EUR/CHF rate below 1.20), Trichet noted the independence of the SNB and its decision. He also commented on the close relationship between the ECB and the SNB. 


1. Eurostat 31 August 2011
2. Markit 5 September 2011
3. Eurostat 31 August 2011
4. ECB 2 September 2011
All other data source: BlackRock DataStream September 2011

This material is for distribution to Professional Clients and should not be relied upon by any other persons. Research in this document has been produced and may been acted on by BlackRock for its own purposes. The views expressed do not constitute investment advice and are subject to change. All financial investments involve an element of risk. Therefore, the value of your investment and the income from it will vary and your initial investment amount cannot be guaranteed. Past performance is not a guide to future performance and should not be the sole factor of consideration when selecting a product. Issued by BlackRock Investment Management (UK) Limited (authorised and regulated by the Financial Services Authority). Registered office: 12 Throgmorton Avenue, London, EC2N 2DL. Registered in England No. 2020394. Tel: 020 7743 3000. For your protection, telephone calls are usually recorded. BlackRock is a trading name of BlackRock Investment Management (UK) Limited.

 

The UK Monetary Policy Committee (MPC) opted to keep base rates at 0.5% and maintain its asset purchase programme (quantitative easing) at £200bn.

  • Concern about the outlook for global markets, with a focus on the euro area, drove the continuation of the Bank of England’s policy of low interest rates and no additional quantitative easing.
  • Despite having changed significantly during the first half of the year, market consensus is now that the first rate hike will be more than 12 months away (February 2013). The domestic growth outlook for the UK remains challenging and faces macroeconomic headwinds resulting from the funding and deficit crises in Europe and the US. There has also been a visible increase in the political wrangling over the management of these issues. Against this backdrop, we don’t expect to see a change in the near term, with rates on hold for the foreseeable future.     

Background

  • In its latest quarterly Inflation Report, published 10 August, the Bank of England lowered the forecast for growth and near-term inflation. The Bank now predicts growth in 2011 to be around 1.4-1.5%, down from its previous estimate of approximately 1.8%.
  •  The Inflation Report also predicted that inflation may reach 5% this year, before falling back next year. Governor Mervyn King stated[1]: “Inflation has been pushed up by rises in energy and import prices, and the increase in the standard rate of VAT. It is likely to rise further over the next few months, possibly to 5%, as a result of another round of gas and electricity price increases. Then, from around the turn of the year, it should begin to fall back as the effect of temporary factors dissipates and the margin of slack in the economy, especially in the labour market, persists”.
  • The minutes from the August MPC meeting showed a unanimous decision to maintain base rates at 0.5%, with Spencer Dale and Martin Weale both changing their votes from July when they had elected to raise Bank Rate by 25bp. Adam Posen was, yet again, alone in voting for an additional £50 billion of QE[2].
  • Annual CPI inflation remains significantly above the Bank’s 2% target and rose in July to 4.4%, up from 4.2% in June[3]. Meanwhile, the Citi/YouGov poll showed that inflation expectations for the year ahead remained unchanged in August at 3.5%[4], while expectations over the longer term (5-10years) were also stable at 3.7%. 
  • Recent economic data has been generally weak. Purchasing manager index (PMI) data disappointed in August. The services PMI dropped to 51.1 in August, from 55.4 in July, while the manufacturing PMI fell to 49.0 from a revised 49.4 in July and construction dropped to 52.6 from 53.5. A figure below the important 50-level usually suggests contraction. Among the components of the manufacturing PMI, output fell to 48.9, new capital goods orders dropped to 47.1, new export orders fell to 46.6 and employment declined to 48.9 – its first sub-50 reading since 2009[5].
  • However, manufacturing output increased in July, by 0.1% month on month, after a decline of 0.4% in July[6]. 
  • Consumer and business sentiment has also softened. The Confederation of British Industry’s survey on consumer and business services was weak for August, with a sharp drop in optimism from 10 to -29 in consumer services and from 23 to -22 in business services[7]. Meanwhile, the Gfk consumer confidence survey declined slightly in August to -31, from -30 in July.
  • Labour market data has also disappointed, with the unemployment rate rising to 7.9% in June, up from 7.7% in March, according to the labour force survey.
  • In some better news for the housing market, data releases from the Bank of England and from the British Bankers’ Association both showed that mortgage approvals increased in July. 


Comments from Paul Shuttleworth, Head of Sterling Fixed Income at BlackRock and fund manager of the BlackRock Corporate Bond Fund:  
 

  • The European crisis highlights the impact that slow moving and poorly conceived policy decisions can have on financial markets. Liquidity has been provided in an attempt to address a solvency problem, however, markets remain unconvinced of the ultimate efficacy of each successive “solution” to the widening of peripheral country debt spreads.
  • The expanding European sovereign debt crisis continues to heighten the risk of a significant slowdown in European growth. In the UK, impaired household balance sheets combined with fiscal retrenchment will continue to weigh on domestic consumption. Given this, we remain in consensus with the market and believe that official interest rates in the UK will stay ‘lower for longer’ and that there may come a time for further coordinated central bank action.
  • The US downgrade which took place last month has not had a significant bearing on our positioning - we believe that US government debt will continue to serve its traditional role as a hedge against risk and continues to be a safe haven for investors globally. However, it is fair to say that the gilt market is likely to remain a hostage to global economic developments in the months ahead - growth prospects, inflation and progress on the government deficit will be pivotal for the market.
  • As we continue into the latter part of 2011, increased levels of volatility in the macro environment will remain the norm and we are therefore likely to continue to be relatively cautious in our positioning.
  • Meanwhile, for corporate bonds, the environment continues to be challenging.  Liquidity has dried up in a manner reminiscent of the onset of the financial crisis when Lehman defaulted back in September 2008. Credit spreads (the yield pick up above gilts) continued to increase during August, indicating that government bonds once again outperformed corporate bonds. Corporates have given back all their gains since the start of 2011 and spreads are back at levels last seen in the latter part of 2009. The issue remains the same – the market perceives that global governments (in Europe and the US) have not done enough to ensure the foundation of the sovereign and financial sectors. As a result the corporate financial sector continues to bear the brunt, in particular the banking sub sector where a lot of peripheral government bond exposure is held. 
  • The Sterling Non Gilt index widened 48bps over the month of August, while the financial sector widened 112bps. 
  • Positioning within the BlackRock Corporate Bond Fund remains closer to home and, with supply remaining light, we look for tactical opportunities to buy and sell on specific credit holdings, keeping transaction costs low due to the elevation in illiquidity. If anything, these setbacks in markets provide an opportunity for us to increase exposure. However, we want to be sure of greater stability in the macro environment ahead of adding to our holdings.
  • Recently we took profit on our US dollar denominated holdings, following strong outperformance of US yields relative to equivalent UK bonds. This exposure has long been a diversifying position for the Fund and has offered some protection against recent negative performance coming from corporate allocations.
  • We continue to make use of tactical derivative strategies, such as credit default swaps, to protect the portfolio from negative market movements.
  • We maintain our long-held overweight to financials and still believe this is best expressed in the insurance sector where volatility, regulatory risk and potential supply are all significantly lower. Within non-financials, corporate balance sheets remain healthy and global default rates remain very low and we believe that carefully selected holdings in this sector will weather the storm.
  • We also maintain a key focus on carefully selected names in the asset-backed sector, however, these have suffered more recently given the weak domestic economic outlook and ratings agency activity. On a stock selection basis, we remain comfortable with our exposure.
  • The road ahead is going to be a volatile one and while the risks of a possible recession in the UK have risen, this is not our base case. We remain focused on selecting the best names for the portfolio and believe that this will enable the Fund to continue performing well over the long term. In our view, credit spreads will be tighter in 12-18 months from now.
  • We believe that fixed income forms a key part of any well-constructed, diversified portfolio and that, while volatility has increased, active management of corporate bonds is the right approach.


1. 10 August 2011, Inflation Report press conference
2. Bank of England, 17 August 2011
3. ONS August 2011
4. YouGov August 2011
5. Markit September 2011
6. ONS 7 September 2011
7. CBI August 2011
All other data source: BlackRock DataStream September 2011

Issued by BlackRock Investment Management (UK) Limited, authorised and regulated by the Financial Services Authority.  Registered office: 12 Throgmorton Avenue, London, EC2N 2DL. Tel: 020 7743 3000. Registered in England No. 2020394. For your protection telephone calls are usually recorded. BlackRock is a trading name of BlackRock Investment Management (UK) Limited.

Past performance is not a guide to future performance. The value of investments and the income from them can fall as well as rise and is not guaranteed. You may not get back the amount originally invested. Changes in the rates of exchange between currencies may cause the value of investments to diminish or increase. Fluctuation may be particularly marked in the case of a higher volatility fund and the value of an investment may fall suddenly and substantially. Levels and basis of taxation may change from time to time.

BlackRock Corporate Bond Fund invests a large portion of assets which are denominated in other currencies; hence changes in the relevant exchange rate will affect the value of the investment. Some or all of the Manager’s annual charge for the Fund is taken from capital rather than from income. Whilst this increases the yield, it reduces the potential for capital growth. The fund invests in high yielding bonds. Companies who issue higher yield bonds typically have an increased risk of defaulting on repayments. In the event of default, the value of your investment may reduce. Economic conditions and interest rate levels may also impact significantly the values of high yield bonds. The fund invests in fixed interest securities such as corporate or government bonds which pay a fixed or variable rate of interest (also known as the ‘coupon’) and behave similarly to a loan. These securities are therefore exposed to changes in interest rates which will affect the value of any securities held. The Distribution Yield provides an indication of income payable by the Fund over the next 12 months based on the portfolio as at the date of calculation. The Underlying Yield reflects the annualised income net of expenses calculated in accordance with relevant accounting standards. Where the Fund elects to distribute income on a coupon basis rather than in accordance with these accounting methods, the Distribution Yield will differ from the Underlying Yield. Similarly, if some or all of the Fund's expenses are charged to capital, the Distribution Yield will be higher than the Underlying Yield but this may reduce the potential for capital growth. The published figures do not reflect any initial charges nor the impact of tax which may be incurred by an investor.

Any research in this document has been procured and may have been acted on by BlackRock for its own purpose. The results of such research are being made available only incidentally. The views expressed do not constitute investment or any other advice and are subject to change. They do not necessarily reflect the views of any company in the BlackRock Group or any part thereof and no assurances are made as to their accuracy.

This document is for information purposes only and does not constitute an offer or invitation to anyone to invest in any BlackRock funds and has not been prepared in connection with any such offer.

This material is for distribution to Professional Clients (as defined by the FSA Rules) and should not be relied upon by any other persons.

  • On Friday night in the US, after the stock market had closed, S&P downgraded its rating for long-term US debt to AA+, from AAA, with a negative outlook. The other ratings agencies have not followed suit, leaving US long-term credit with a split rating.
  • At BlackRock we put a great deal of work into preparing and positioning portfolios for the possibility of this downgrade, which had been signalled by S&P several weeks ago. We would always expect our analysts to be ahead of the ratings agencies, rather than reactive, and for some time have increased the quality and liquidity of fixed income portfolios. This does not, however, mean that they have been immune to the increased volatility of recent weeks.
  • We view the downgrade by S&P as another signal to investors that the current global economic environment is uncertain. Most recent US economic data has been very weak, with the exception of Friday’s payrolls data. US GDP is running significantly below the US Federal Reserve (Fed)'s forecast for 2011 of 2.7-2.9%[1], which itself was only revised down in June from a previous estimate of 3.1-3.3%[2].
  • Given this environment, any tightening of monetary policy by the Federal Open Market Committee (FOMC), which incidentally meets this week, is likely to have receded even further into the future. The recent rally in Treasuries partly reflects reduced market consensus expectations of rising interest rates in the near term, as well as a desire among investors for a safe haven amidst high levels of uncertainty and market volatility.


This update is based on the views of leading BlackRock investment professionals:
Robert Fairbairn, Head of Global Client Group
Ewen Cameron Watt, Chief Investment Strategist of the BlackRock Investment Institute Peter Fisher, Head of Fixed Income Portfolio Management
Bob Doll, Chief Equity Strategist
Richard Turnill, Head of the Global Equities Team

 

[1] Federal Reserve June 2011
[2] Federal Reserve April 2011
All data source BlackRock August 2011 unless otherwise stated

 

Past performance is not a guide to future performance.  The value of investments and the income from them can fall as well as rise and is not guaranteed.  You may not get back the amount originally invested.  Changes in the rates of exchange between currencies may cause the value of investments to diminish or increase.  Fluctuation may be particularly marked in the case of a higher volatility fund and the value of an investment may fall suddenly and substantially.  Levels and basis of taxation may change from time to time.   Any research in this document has been procured and may have been acted on by BlackRock for its own purpose.  The results of such research are being made available only incidentally.  The views expressed do not constitute investment or any other advice and are subject to change.  They do not necessarily reflect the views of any company in the BlackRock Group or any part thereof and no assurances are made as to their accuracy.

Overall, the European fiscal crisis is a greater threat to market confidence that S&P’s downgrade of US long-term debt. In recent days, fears of contagion beyond Greece into other countries in the eurozone periphery have caused Spanish and Italian bond yields to increase significantly, while French and Belgian spreads over Bunds have also widened slightly.

Italian Prime Minister Silvio Berlusconi announced on Friday that Italy will speed up its fiscal austerity plans to balance the budget by 2013.

Last week, as expected, the European Central Bank (ECB) kept the main refinancing rate at 1.5%. However, with the increasing stress on Spanish and Italian yields, it responded by reintroducing a six month long-term tender with full allocation as well as continuing to supply unlimited liquidity in shorter tenders until year end through its main refinancing operations. It will also intervene in the government bond market by reactivating the Securities Market Programme (SMP), which had not been used in recent months.

Over the weekend the European Central Bank (ECB) announced that it would purchase Italian and Spanish government bonds. We view this as a temporary measure, until the European Financial Stability Fund (EFSF) gains political clearance from all 17 members of the eurozone in September.

ECB intervention yesterday helped to reduced the yield on Spanish and Italian government bonds. However, if Spain and Italy were to later on become recipients of the EFSF then the programme would fail because that would mean that 80% of the total guarantee would fall on France and Germany. Since S&P downgraded US long-term debt, attention has turned to other countries with AAA ratings that could potentially be at risk, particularly France.

European growth is likely to be lower in 2012 than most market commentators previously expected. Besides the blow to business and consumer confidence caused by the sovereign debt crisis, slowing global economic growth may also impact the hitherto robust demand for exports from northern Europe.

 

All data source BlackRock August 2011 unless otherwise stated 

This update is based on the views of leading BlackRock investment professionals:

Robert Fairbairn, Head of Global Client Group
Ewen Cameron Watt, Chief Investment Strategist of the BlackRock Investment Institute Peter Fisher, Head of Fixed Income Portfolio Management
Bob Doll, Chief Equity Strategist
Richard Turnill, Head of the Global Equities Team

Past performance is not a guide to future performance. The value of investments and the income from them can fall as well as rise and is not guaranteed. You may not get back the amount originally invested. Changes in the rates of exchange between currencies may cause the value of investments to diminish or increase. Fluctuation may be particularly marked in the case of a higher volatility fund and the value of an investment may fall suddenly and substantially. Levels and basis of taxation may change from time to time. Any research in this document has been procured and may have been acted on by BlackRock for its own purpose. The results of such research are being made available only incidentally. The views expressed do not constitute investment or any other advice and are subject to change. They do not necessarily reflect the views of any company in the BlackRock Group or any part thereof and no assurances are made as to their accuracy.

Equity Markets – US

  • The S&P 500 is now priced very low, at around 12x trailing earnings. The last time this occurred was decades ago, when the yield on 10-year Treasuries around 8%[1].
  • With the bulk of second-quarter earnings now released, 75% of companies exceeded earnings expectations and 72% exceeded revenue expectations[2] .

Equity Markets – Global

  • We are witnessing the continuation of two important trends. The first is the shift in economic power from west to east, while the second is the perception of sovereigns versus corporates.
  • We have already started to see earnings downgrades in Europe and Japan, but not really yet in the US. An increase in the potential cost of capital would further detract from prospects for economic growth.
  • The cash position of corporates remains strong, particularly in comparison to that of sovereigns. Equity valuations are compelling but that means that equity risk premia are high. Furthermore, cheap valuations in turbulent market conditions do not lead immediately to market snap backs. We favour high quality stocks, particularly as the recent selloff has been broad based and relatively indiscriminate, despite strong cash positions. We also favour emerging markets.

Factors to be Aware of

  • Private sector leverage is far lower than it had been in 2008.
  • At the same time significant declines in equity indices and spikes in volatility do force futures based investors to increase cash collateral levels, thereby leading to a selling spiral and valuations overshoot.
  • Most of the leverage is now on public sector balance sheets, which means that there will be far less liquidation. We need to be aware of the political and fiscal realities, and western governments need to reduce their sovereign debt.
  • Central banks are likely to respond as positively as they can to the current uncertain environment, aware of the need for monetary policy support at a time of strong pressure on governments to reduce rascal deficits.
  • In recognition of the need to effectively assess sovereign risk, BlackRock has developed a proprietary index of sovereign vulnerability risk, the BlackRock Sovereign Vulnerability Index.


This update is based on the views of leading BlackRock investment professionals:
 Robert Fairbairn, Head of Global Client Group
Ewen Cameron Watt, Chief Investment Strategist of the BlackRock Investment Institute Peter Fisher, Head of Fixed Income Portfolio Management
Bob Doll, Chief Equity Strategist
Richard Turnill, Head of the Global Equities Team

 

[1] BlackRock DataStream August 2011

[2] BlackRock DataStream August 2011

All data source BlackRock August 2011 unless otherwise stated 

Past performance is not a guide to future performance. The value of investments and the income from them can fall as well as rise and is not guaranteed. You may not get back the amount originally invested. Changes in the rates of exchange between currencies may cause the value of investments to diminish or increase. Fluctuation may be particularly marked in the case of a higher volatility fund and the value of an investment may fall suddenly and substantially. Levels and basis of taxation may change from time to time. Any research in this document has been procured and may have been acted on by BlackRock for its own purpose. The results of such research are being made available only incidentally. The views expressed do not constitute investment or any other advice and are subject to change. They do not necessarily reflect the views of any company in the BlackRock Group or any part thereof and no assurances are made as to their accuracy.  

Nigel Bolton, Head of the European Equity Style Diversified Team

How do we see the current situation?

Recent declines in equity markets appear to have been primarily triggered by comments from the European Central Bank (ECB) yesterday.

It was only two weeks ago that the EU leadership announced a plan aimed at resolving the Greek debt crisis, providing for the restructuring of Greek debt with lower coupon payments and longer duration in exchange for the acceleration of much needed austerity plans. 

However, after an initial bounce, investors soon resumed their bearish posture as the finer details of the proposal made it look less convincing than first hoped.  Market anxiety was further exacerbated by a lack of political direction created by the traditional summer holiday period in Europe.  In the following weeks, faced with this political vacuum, investors have been left pondering whether European Financial Stability Facility measures have sufficient fire power to avert a contagion effect in Spain and Italy.  These concerns have been reflected in European investors selling financials stocks and moving into defensive areas. Bond markets have seen bond yields for Spain and Italy approach 6%.

Markets have been further spooked by US politicians' delayed agreement of the necessary increase in the debt ceiling required to avoid a default, which had the potential to send the global economy into another 2008 style financial crisis.  That, combined with weak second quarter  European companies’ earnings  results and the looming fiscal drag from the US and European austerity measures, led investors to assume downward revisions to GDP growth were inevitable and a return to recession more likely.

However, the answer to the question of whether we are going into a synchronized global recession or whether this is a mid cycle slowdown remains elusive given the political dimension. 

How are we positioned?

Since the beginning of the year, we have taken decisive action to protect portfolios from the worst impact of the sovereign debt crisis.  At the end of July our portfolios were significantly underweight financials and peripheral banks in particular.  At the country level we are broadly underweight Ireland, Greece and Portugal.  We recently increased the underweight exposure to Spain and Italy by taking profits in the rally post the EU leadership summit and rescue plan announcement. 

In previous outlook statements we had indicated that we could see a number of pressures building at the corporate level and that second quarter results would be tough.  Specifically, we highlighted that rising input prices were resulting in margin pressure across a number of industries. This has indeed been the case. However, earnings have also been affected by currency headwinds which have been more pronounced than the market anticipated. With the exception of luxury goods and autos, most sectors have experienced earnings downgrades from sell side analysts over the last five weeks.

With earnings momentum rolling over, this opened up a segment of the market which previously looked less attractive.  Namely, less cyclical quality growth companies, with stable earnings, cash generative businesses with the potential to maintain returns to shareholders via dividends and/or share buybacks.  Many such companies sit within healthcare, telecoms and the food & beverage sectors.  This is balanced with holdings were we see structural growth remaining, predominantly via holdings in the consumer discretionary, industrials and materials sectors. 

We think this portfolio structure positions us well should a slowdown in economic activity occur, whilst still allowing us to benefit from pockets of structural global growth. We remain of the view that the European equity universe offers some of the best businesses in the world and we are being vigilant in identifying some of those which represent attractive buying opportunities during this period of risk aversion.

This material is for distribution to Professional Clients and should not be relied upon by any other persons. Research in this document has been produced and may been acted on by BlackRock for its own purposes. The views expressed do not constitute investment advice and are subject to change. All financial investments involve an element of risk. Therefore, the value of your investment and the income from it will vary and your initial investment amount cannot be guaranteed. Past performance is not a guide to future performance and should not be the sole factor of consideration when selecting a product. 


Financial markets have experienced high levels of volatility over the past few weeks, dogged by the US debt ceiling impasse, further concerns about peripheral Europe and weak economic data. Over the last few days, however, volatility has significantly increased further.

Eurozone debt crisis      

  • In recent days, fears of contagion beyond Greece into other countries in the eurozone periphery once more resurfaced, putting upward pressure on Spanish and Italian bond yields. Europe has not come up with a proper solution for the periphery and markets are effectively pricing in a Greek default at some point over the next three years.     
  • Yesterday, as expected, the European Central Bank (ECB) kept the main refinancing rate at 1.5%. However, with the increasing stress on Spanish and Italian yields, it responded by reintroducing a six month long-term tender with full allocation as well as continuing to supply unlimited liquidity in shorter tenders until year end through its main refinancing operations. It will also intervene in the government bond market by reactivating the Securities Market Programme (SMP), which had not been used in recent months.
  • The market’s reaction, with a sharp sell off in equities and spike in Spanish and Italian yields, showed investors are underwhelmed by the ECB’s response and so, yet again, market behaviour is now pressuring policy response. 
  • Major stock markets across the world have tumbled, while US Treasury yields yesterday hit new lows for this year.

US economic difficulties

  • Recent US economic data has been very weak. US GDP is most worrying, running significantly below the US Federal Reserve (Fed)'s forecast for 2011 of 2.7-2.9%, which itself was only revised down in June from a previous estimate of 3.1-3.3%.
  • Regarding the US debt ceiling, the USD 2.1 trillion increase should tide the US Treasury over until after the elections at the end of 2012. There will also be approximately USD 900 billion of expenditure cuts over ten years, while a commission will be tasked with identifying a further USD 1.5 trillion deficit reduction.
  • While the US debt ceiling issue appears to have been resolved, at least in the near term, there are signs from early survey measures that the political standoff may have set back economic activity.
  • While a double dip into recession is unlikely, data releases are weak and this cannot be solely blamed on the devastating events in Japan. Either there will be a strong bounce in activity in the second half of the year or US growth may effectively stall.

Global repercussions

  • Yesterday the Bank of Japan intervened in currency markets, selling yen, in an attempt to halt the rise of the yen against the US dollar. Yen depreciated initially but has since rebounded. The chairman of the Swiss National Bank, Philipp Hildebrand, also commented that the central bank will not tolerate a further appreciation in the franc without acting.
  • ECB president Jean-Claude Trichet summed up the sovereign problems nicely in an interview published 27 July. “The pressure observed on sovereign risks is not solely a European problem, it is also a global problem. The United States and Japan also have major fiscal problems, as you well know. The paradox is that, from a global perspective, the euro area is in a far better situation, with a consolidated fiscal deficit of around 4.5% of GDP this year, compared with approximately 10% of GDP for these other two countries. On the other hand, individual countries in Europe, in particular Greece, are in a much more difficult situation. All the decisions taken in Brussels by the Heads of State or Government are important for the financial stability of the euro area”.
  • The nature of sovereign debt as an asset is challenged by this crisis. Sovereign debt was, until recent years, a type of high-powered money substitute. Banks used it as collateral for funding and regulated institutions hold significant amounts of sovereign bonds as regulatory capital. In consequence of the financial crisis, fiscal revenues have fallen and government borrowing levels increased. This in turn has made investors reassess sovereign debt as a riskier asset (a credit rather than interest rate play) and less prepared to hold these assets if perceived risks increase.
  • Bond indices differ from equity indices in that they reward failure. That is, the more debt raised the higher the weight of the issuer in an index and, of course, the greater risk that the issuer may be unable to meet their obligations if economic circumstance changes. In contrast, equity indices generally reward success with growing companies taking a larger weight in indices.
  • In recognition of this trend and the need to effectively assess sovereign risk,  BlackRock has developed a proprietary index of sovereign vulnerability risk, the BlackRock Sovereign Vulnerability Index.
  • There are patches of optimism within this turmoil. The market volatility and equity market sell-off will create pockets of opportunity for flexible and nimble investors.
  • The focus today will be on US employment data and any statements from European leaders.

 

This material is for distribution to Professional Clients and should not be relied upon by any other persons. Research in this document has been produced and may been acted on by BlackRock for its own purposes. The views expressed do not constitute investment advice and are subject to change. All financial investments involve an element of risk. Therefore, the value of your investment and the income from it will vary and your initial investment amount cannot be guaranteed. Past performance is not a guide to future performance and should not be the sole factor of consideration when selecting a product.


Council members of the European Central Bank (ECB) have voted to keep the benchmark interest rate unchanged at 1.5%


Background   

  • The last change was in July, when the main refinancing rate was increased by 0.25% to the current 1.5% level.
  • In economic data releases, the flash estimate for HICP annual inflation in the eurozone was 2.5% in July, down from 2.7% in June[1]. 
  • The region’s unemployment rate remained 9.9% in June. Amongst the member states, Spain had the highest unemployment rate at 21.0%, while it was lowest in Austria at 4.0%[2]. 
  • Purchasing Managers’ Index (PMI) data for the eurozone disappointed in July. The manufacturing PMI declined from 52.0 in June to 50.4 in July, and the services PMI declined over the same period from 53.7 to 51.4. Both of the weak readings were below consensus expectations.
  • According to the European Commission’s (EC) survey, consumer confidence declined to -11.4 in July, from -10.3 in June. The EC’s survey on economic sentiment in the eurozone also fell, to 103.2 in July from 105.4 in June, reinforcing the message of weakening growth from the PMI data. This survey also included a quarterly question on capacity utilisation, which disappointed consensus expectations with a fall from 81.6 in the second quarter to 80.7 in the third quarter.
  • However, the binary nature of the region’s economy remains, with German sentiment remaining high in the EC survey, despite recent declines. There was also good news in Germany from retail sales figures, which rebounded by 6.3% month on month in June, after declining 2.5% in May.
  • Regarding the sovereign debt problems in the eurozone periphery, the summit of EU leaders in July resulted in a Greek bailout package of EUR 109 billion. Private sector involvement was also agreed and the European Financial Stability Facility has been granted the power to offer assistance to countries not currently in a formal programme and to buy bank debt.
  • In an interview published 27 July[3], ECB president Trichet stated: “The pressure observed on sovereign risks is not solely a European problem, it is also a global problem. The United States and Japan also have major fiscal problems, as you well know. The paradox is that, from a global perspective, the euro area is in a far better situation, with a consolidated fiscal deficit of around 4.5% of GDP this year, compared with approximately 10% of GDP for these other two countries. On the other hand, individual countries in Europe, in particular Greece, are in a much more difficult situation. All the decisions taken in Brussels by the Heads of State or Government are important for the financial stability of the euro area”.
  • In recent days fears of contagion have once more resurfaced, with upward pressure on Spanish and Italian bond yields.

Comments from Michael Krautzberger, Head of Euro Fixed Income within BlackRock's Fundamental Fixed Income Portfolio Management Group:

  • The ECB acknowledged the recent weaker prints of economic data in the Eurozone and have tuned down their description of the growth situation. Further they stress that we currently live in a time of 'particularly high uncertainty'.  
  • Furthermore their focus returned from rate normalisation to crisis management. They reintroduced a six month long-term tender with full allocation and will continue to supply unlimited liquidity in shorter tenders until year end as well. They also reactivated their Securities Market Programme (SMP) which has not been used in the previous months despite the fact that it was never formally stopped/ paused.
  • But while the recent market worries focussed on Italy and Spain and the ability of the eurozone to help countries of this size, the ECB apparently is so far only buying the smaller countries Ireland and Portugal. As their interventions in those countries have not been successful before, and as the market was hoping for activity in the bigger countries, the immediate market reaction was disappointment and risk markets are weaker. The size of those countries and therefore the size of necessary interventions make the hurdle for intervention in those markets higher. At the moment it looks likely that the nervousness in those markets will persist until we see concrete action in those countries. On the positive side, with the reactivation of the SMP already decided, the ECB could potentially react very quickly to additional market weakness and change their country focus. Volatility in the market will stay elevated.
  • On official interest rates we expect the ECB to be on hold at least for the next few months.

[1] Eurostat 29 July 2011
[2] Eurostat 1 August 2011
[3] Published on the ECB website, 27 July

 

This material is for distribution to Professional Clients and should not be relied upon by any other persons. Research in this document has been produced and may been acted on by BlackRock for its own purposes. The views expressed do not constitute investment advice and are subject to change. All financial investments involve an element of risk. Therefore, the value of your investment and the income from it will vary and your initial investment amount cannot be guaranteed. Past performance is not a guide to future performance and should not be the sole factor of consideration when selecting a product

The UK Monetary Policy Committee (MPC) opted to keep base rates at 0.5% this month and maintain its asset purchase programme (quantitative easing) at £200bn.
Overview

  • The minutes from the July meeting were consistent with June and showed a 7-2 split in favour of maintaining base rates at 0.5% and an 8-1 split to hold the stock of asset purchases in at £200bn.  We expect a very similar split in voting this month.  While it’s certain that discussion will take place around the possibility of further monetary purchases, with inflation remaining sticky and likely to peak above 5% in the second half of 2011, it’s unlikely this is an imminent possibility.
  • Despite having changed significantly over the last few months, the market consensus for rate hikes has become even more pronounced since our last observation in July, with the first hike now priced into the gilt market for February 2013.  With additional macroeconomic concerns being driven by debt/deficit concerns in Europe and the US (not to mention the ongoing downgrade ratings rhetoric), and a challenging growth outlook in the UK, we don’t expect to see a change in interest rates any time soon.

Background

  • In its annual report on the UK economy, the International Monetary Fund (IMF) noted that “implementation of a wide-ranging policy program is underway, aiding the post-crisis repair of the economy. However, the recovery stalled over the last several months, inflation remains elevated, and unemployment is still unacceptably high. The financial system has stabilised and bank balance sheet repair continues, but this process is not complete and is vulnerable to setbacks[1]. 
  • The IMF also stated that fiscal headwinds will continue as the government moves toward a more sustainable fiscal position and the unemployment rate is expected to decline only slowly. However, the outlook for private investment is brighter.  
  • In relation to monetary policy, the IMF commented that inflation levels above the MPC’s 2% target reflect transitory factors and monetary policy remains appropriate for now: if growth resumes as expected in the coming quarters, the case for beginning to withdraw some monetary stimulus will slowly increase. 
  • The Bank of England Agents survey shows modest economic growth and buoyant exports but consumer spending remains sluggish. 
  • CPI inflation fell in June to 4.2% year on year[2], from 4.5%. Meanwhile, the Citi/YouGov poll showed that inflation expectations for the year ahead dropped to 3.5% in July[3], from 3.9% in June. 
  • The first estimate of 2Q GDP growth came in at 0.2% quarter on quarter[4]. The ONS highlighted the additional (royal wedding) bank holiday, Japanese tsunami, Olympic ticket sales and record warm weather in April as one-off factors that negatively impacted the second quarter data by up to 0.5%. 
  • Retail sales were better than expected at 0.8%m/m in June . The Purchasing Managers Index[5] for services exceeded consensus expectations in July at 55.4 but manufacturing disappointed, falling to 49.1.
  • The minutes from the July MPC meeting showed that Spencer Dale and Martin Weale both voted for a 25bp rise in Bank rate, while Adam Posen voted for additional QE[6].

Comments from Paul Shuttleworth, Head of Sterling Fixed Income at BlackRock and fund manager of the BlackRock Corporate Bond Fund: 

  • Given the ongoing fragility of the economic recovery, there appears to be consensus within the MPC committee that inflation will remain high and growth will remain weak in the short term.  Given that Q1 GDP was only 0.5% and Q2 GDP estimates sit at only 0.2%, this suggests that Q3 and Q4 of 2011 will need to be significantly stronger quarters for predicted growth forecasts to remain on track.  We see this as an unlikely outcome at this point and expect that we’ll soon see growth forecasts being revised downwards to accommodate this change in view.  Investors had moved to completely discount the probability of a double dip recession in the UK, however, speculation about this is likely to rise.
  • The situation for UK Households has not changed. Household incomes remain squeezed,  consumer confidence challenged and lending remains muted.  Our analysis shows that UK household real disposable income is in decline to a degree that is worse than back in the late 1970’s and early 1980’s.  It is against this backdrop that we believe we’re quite unlikely to face an environment of increasing interest rates.  The labour market seems to be keenly focussed on maintaining employment and protecting pensions rather than fighting for increased wages at this stage.
  • While the consensus for hikes in UK interest rates remains firmly fixed on next year, the performance of UK gilts continues to be influenced by the ongoing spike in risk aversion in broader global markets.  A risk off environment proliferated into June as concern around the management of the debt crisis in the European periphery drove investors to lose confidence in policy makers.  This was further exacerbated during July when it became apparent that US politicians were struggling to agree on a plan to reduce their budget deficit while raising the US debt ceiling.  This was followed swiftly by ratings agencies putting the US AAA rating on watch for downgrade.  As a direct result, UK gilt yields (considered a safe haven) continued to fall.  The UK 10-year has now touched historic lows, trading at around 2.7%.  The positive side of lower yields means the UK Government is able to finance itself at cheap levels however; it means cash returns are likely to stay low.  Fiscal slippage remains a key risk.
  • While trouble in the global economy continues to dominate the headlines, we expect to see elevated market volatility.  Even as the US passed the extension to their debt ceiling into law only days ago, this has done little to reassure the markets.  
  • Meanwhile, for  corporate  bonds, the environment remains equally challenging with credit spreads (the yield pick up above gilts) continuing to widen through the month of July, indicating that government bonds outperformed corporate bonds.  This has largely been driven by the markets perception that global governments (in Europe and the US) have not done enough to sure up the foundation of the sovereign and financial sectors.  As a result the corporate financial sector continues to bear the brunt, in particular the banking sub sector where a lot of peripheral government bond exposure is held.
  • The Sterling Non Gilt index widened 10bps over the month of July; while the financial sector widened 25bps.  Against this backdrop, wide bid/offer spreads and illiquidity remained.  As a result we’ve continued to maintain our more cautious approach in the short term.
  • Positioning within the BlackRock Corporate Bond Fund remains closer to home and with supply remaining light, we look for tactical opportunities to buy and sell on specific credit holdings, keeping transaction costs low due to the elevation in illiquidity.  If anything, these set backs in markets provide an opportunity for us to increase exposure however, we want to be sure of greater stability in the macro environment ahead of adding to our holdings. 
  • Recent opportunities to be active in the market included the recent reopening of the UK covered bond market which saw us add to our exposure at attractive valuation levels and improved credit quality.  In addition, we've made use of tactical derivative strategies, such as credit default swaps, to protect the portfolio from negative market movements.
  • We continue to maintain a long-held overweight to financials and still believe this is best expressed in the insurance sector where volatility, regulatory risk and potential supply are all significantly lower.  Within non-financials, corporate balance sheets remain healthy and global default rates remain very low and we maintain a key focussed on carefully selected names in the asset-backed sector. Stock selection will be a key driver of returns during 2011 and we maintain a preference for companies with strong consistent cash flows and credible management teams.
  • We believe that fixed income forms a key part of any well constructed, diversified portfolio and believe that active management of corporate bonds should post good returns in 2011. 


[1] Source: IMF 1 August 2011
[2] Source: ONS July 2011
[3] Source: YouGov July 2011
[4] Source: ONS July 2011
[5] Source: Markit/CIPS 
[6] Source: Bank of England, July 2011
All other data source: BlackRock, August 2011

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