To recap, in our bumper Christmas double issue, I explained why a perfect storm was brewing in the European debt markets and why rating agencies would be downgrading credit for the weaker Mediterranean block ('). At the time I thought it was inevitable, given the parlous state of its finances, that Portugal would have to seek a EU bailout from the €750bn (£660bn) European Financial Stability Facility (EFSF) rescue fund by the end of the first quarter of 2011. Public and private debt in the country is an eye-watering 325 per cent of GDP; its banks are completely shut out of the capital markets and wholly reliant on funding from the European Central Bank (ECB); and to compound matters the government is heavily exposed to external overseas funding to bridge a 10 per cent forecast budget deficit.
Portugal credit downgrades
It all came to a head last week when Moody's downgraded the rating on a trio of Portuguese banks - BES, Banco BPI and Banco Comercial Português - and the government was forced to borrow €1bn in six-month and one-year loans at punitive rates of 5.11 per cent and 5.9 per cent, respectively - a hefty two percentage points higher than previous debt auctions - in an attempt to raise the €4.3bn it needs to meet a debt redemption on Friday 15 April.
At the longer end of the curve, Portugal 10-year debt is yielding 10 per cent, making it impossible for the country to borrow longer-term at economic rates of interest. It also means that a greater reliance on short-term debt funding increases roll-over risk and makes lower maturity funding even more expensive. To put this into perspective, Germany's funding rates are a minuscule 1.3 per cent for one-year money and 3.48 per cent for 10-year debt. In the circumstances, the decision for Portugal to formally request IMF and EFSF financial support, believed to be in the order of €80 to €85bn, was inevitable.
However, the human cost of all this should not be forgotten. Unemployment in Portugal is on course this year to hit a 15-year high above 11 per cent and GDP is forecast to contract by around 1.3 per cent, forcing the economy into a second recession in little over three years. And if the bailout is on similar terms to the rescues of both Greece and Ireland, then we can expect a severe austere package conditional on any IMF/EU funding.
A Spanish nightmare
The bigger issue, and one I made a very strong case for four months ago, is whether Spain will be able to avoid the domino effect spreading through the weaker peripheral eurozone. So far, and contrary to what I had expected, investors in the debt markets are betting that it will, with borrowing costs on Spanish 10-year government bonds falling 45 basis points to 5 per cent since the start of this year.
They could be right, but I think they are being incredibly complacent and for one very good reason: the European Central Bank's decision to raise the central bank rate last week by 0.25 per cent and embark on a period of monetary tightening to dampen inflationary pressures is a game-changer of huge proportions. In my view, it has serious ramifications for Spain's fragile banking system, which is far from being out of the woods, having funded a decade-long property boom, during which time residential prices more than doubled before the global financial crisis brought the debt binge party to an abrupt end in the summer of 2007.
The boom has turned to an almighty bust with reported house prices down by almost a fifth - and even more so on the Costas - and a staggering 1m homes lie vacant in a country with a population of only 47m. Prices are now back to 2005 levels, but, given that previous downturns in 1979 and 1991 lasted for upwards of four years before prices hit a trough, according to research from Spanish Property Insight, and the current downturn is coming off the mother of all booms, you wouldn't bet against this property market bubble deflating for some time yet given the glut of properties for sale.
Further property price weakness is a major problem because the Cajas, the regional savings banks, are under government orders to increase their Tier 1 core capital to 10 per cent by September if they are reliant on wholesale capital markets for more than a fifth of their funding, or had less than a fifth of their equity held by private investors. Otherwise the government will take control through the state bailout fund.
Jose Manuel Campa, Spain's economy secretary, claims that the cost of this will be around €20bn, although analysts are far from convinced - with some estimates implying a further recapitalisation of upwards of €80bn will be needed. If this turns out to be the case, then this will put a huge strain on Spain's finances, since the country's gross financing needs are already around €226bn this year, equivalent to over 20 per cent of GDP, according to Barclays Capital.
Interest rates double whammy
Even if we are optimistic and the 17 cajas manage to successfully recapitalise - only five of the 17 meet the 10 per cent rule at present - the problem doesn't end there because it is only reasonable to expect delinquency rates to rise further and bad debts to increase if property prices continue their downward spiral. In a country where a fifth of the working population is unemployed and austere economic programmes are being implemented to try to balance the budget deficit - estimated to be 7 to 8 per cent of GDP in 2011 - it goes without saying that the last thing Spain needs is tighter monetary policy. But that is exactly the path the ECB is taking, to try to put a lid on inflation which is running at 2.6 per cent across the eurozone.
And Spain's homeowners are hugely exposed to the rate-setting agenda of the ECB since 80 per cent of all mortgages in the country are variable rate and in effect linked to the rate set by the central bank. Clearly, this situation will take time to unravel, but I can only see bad news emerging from Spain in the months ahead if the ECB continues to raise interest rates, as is now widely expected.
Golden opportunity
Back in December, I argued that the best way to play the eurozone debt crisis was by buying gold and the trade has worked out well with the gold price rising 7.5 per cent from $1,370 per ounce (oz) to a record high of $1,475/oz last week.
Admittedly, it's not just eurozone debt woes that have been driving the gold price as the US Federal Reserve's second round of quantitative easing (QE2) is supportive of commodity prices (). That's not only because some of this cheap money leaks into the commodity complex, but also because it is rational for investors to diversify out of fiat currencies to hedge against the risk that monetary authorities are attempting to monetise deficits by printing money. It is therefore worth keeping a close eye on the minutes from the next Federal Reserve Open Market Committee meetings, scheduled for 26-27 April and 21-22 June, especially as the current $600bn Treasury purchase programme is due to complete by the end of June. Any extension would be very bullish for gold.
The supply/demand equilibrium is also supportive of the bull case, especially as the official sector have been net purchasers for eight consecutive quarters and legacy hedge books from the world's largest mining groups have been unwound, so the industry has a vested interest in maintaining spot prices as high as possible.
In the circumstances, and given the ticking time bomb in the Spanish banking system, I have little reason to change my long held bullish view on gold.
Trading strategy
From a charting perspective, it looks to me that the break-out in the gold price above the prior $1,440/oz highs has signalled a new leg up for the commodity, especially as the breach of this level completed a bullish inverse head-and-shoulders pattern that formed over the past five months.
So my advice is to try and enter into new gold positions on any pull back to around the neckline of the head and shoulders pattern around $1,440/oz and then target a move to $1,550/oz in the coming months, which would represent a doubling of the price since it formed a major low of $773/oz in mid-October 2008 during the worst of the global financial crisis.
Investing in gold
There are several ways to gain exposure to the metal. ETF Securities' Gold Bullion Securities (www.etfsecurities.com) has two exchange-traded funds products that track the gold price in US dollars (TIDM: GBS) or in sterling (TIDM: GBSS).
Alternatively, Royal Bank of Scotland (http://ukmarkets.rbs.com) has a product I like that hedges off the currency risk, thereby enabling UK investors to play the gold price without taking on foreign-exchange risk. The first is RBS Gold Bullion GBP Hedged Tracker, RB81, which tracks the performance of the spot gold price less the annual management charge of 0.7 per cent. Trading on a tight 0.2 per cent bid-offer spread, and eligible for inclusion in Isas, Sipps and Ucits funds, the product is also exempt from stamp duty. To mitigate the foreign exchange risk RBS takes out monthly positions in the currency markets as a hedge. Given the tight bid offer spread, we should be able to capture all of the 7.5 per cent potential upmove in the gold price over the next few months if my forecast proves correct.
Share recommendations: a recap
Investment company LMS Capital produced bumper full-year results as I anticipated ('Capital Returns', 14 Feb 2011), reporting a 7 per cent increase in net asset value to 90p at December's year-end. And there should be further upside to come as one of the company's quoted UK holdings, speciality pharmaceutical company Prostrakan, received a recommended cash bid of 130p a share only a week after I advised buying shares in LMS at 54.5p. This represents a 26 per cent premium to the value of the holding in LMS's latest accounts and adds a further £4.7m to the company's £253m investment portfolio.
Moreover, shares in Gulfmark Offshore, a US offshore marine services group in the exploration and production of oil and natural gas industry, have rocketed 50 per cent since the start of this year, which adds a further £2.3m of unrealised gains to LMS's portfolio. When combined, this boosts net asset value by 2.5p a share, and when the proceeds from the sale of the stake in Prostrakan are factored in, LMS will shortly have cash of £36m on its balance sheet (net funds of £12.6m), available for new investments.
The shares have moved up 13 per cent to 61.5p since my buy advice and are now well on their way to my six-month price target of 70p. With a further 14 per cent potential upside I continue to rate them a strong buy.
■ Elektron shares have drifted down from last year's high of 44p and, at 33p, are 8 per cent below my 36p recommended buy-in price ('Switching on Elektron', 29 Nov 2011).
But trading remains positive and the company reported in a pre-close statement a few weeks ago that it is on target to hit analysts' earnings estimates. House broker finnCap is looking for adjusted pre-tax profits of £4.9m in the 12 months to 31 January 2011 and underlying EPS of 4.2p based on sales of £49m, up from £29.9m the prior year. The results will be announced on 12 May. On this basis, the shares now trade on 7.6 times earnings and yield 2.3 per cent, assuming a full-year dividend of 0.75p a share is paid. The rating gets even more attractive, with finnCap expecting profits to rise to £6.7m and EPS of 4.6p in the current financial year to January 2012, based on revenues of £67m. And it's not as if there are financial concerns as pro-forma gearing was around 11 per cent post the Hartest acquisition.
However, news that the finance director, Geoff Spink, will be leaving the company after the release of the half-year results in September is not great news as it creates uncertainty and raises concern over a boardroom split. Mr Spink was the former chief executive of Hartest and only became finance director of Elektron in mid-September. Investors may also have been spooked by the fact that the company has a facility in Tunisia, even though the board has not reported any impact from political instability in the region when it released a positive update on its operations this week. I continue to rate the shares a buy ahead of next months full-year results.
■ Bollywood film producer Eros has also announced an upbeat trading statement this week, prompting analysts to upgrade earnings estimates for the current financial year. Peel Hunt now expects pre-tax profits for the 12 months to March 2012 of $73.9m, up from the broker's previous estimate of $65.4m and significantly ahead of the $59.7m forecast for the financial year to March 2011. On this basis adjusted EPS are set to rise by 25 per cent from around 40 cents to 51 cents, equating to 31.2p a share, and means the shares are now rated on 8 times earnings estimates for the year to March 2012. Clearly, the company will have a good news story to tell when it releases results in two months time, and having advised buying the shares at 247p ('Movie Time', 21 Feb 2011), I continue to rate them a strong buy at the current 243p.
■ The M&A activity I was expecting for property company Wichford materialised with the board recommending a merger with Redefine, a £213m closed-ended investment fund majority owned by a major South African real estate group and a 21.7 per cent shareholder in Wichford. A 7.2-for-one all share offer represents a 7 per cent premium to Wichford's share price of 6.7p before the announcement was made and, with Redefine's shares trading at 52p, the bid is currently worth 7.25p a share to Wichford shareholders. However, this is well below the company's last reported EPRA net asset value of 8.67p.
It is disappointing that the eventual bid was not higher, but I believe that the best course of action is to accept the offer as it will put the business on a firmer financial footing and, in time, will offer scope for the value in Wichford's estate to be realised. Unfortunately, this means that you will be sitting on a small net loss following my advice to buy the shares at 8.125p ('Real Estate Profits', 17 Aug 2009), after factoring in net dividends of 1.3p a share paid in the past 18 months. Those of you who took up my subsequent advice to buy at 6.5p ('Small Cap Wonders', 29 Oct 2010 and Wichford Tales, 8 Feb 2011), will be breaking even.
■ The trading signal for my post-Budget trade was triggered this year, which was the cue to buy the FTSE 100 at 5903 at close of trading on Monday 28 March ('Key trades to make in March', 4 Mar 2011). The index has already risen above 6050, but I have decided not to close out this trade on Wednesday 13 April as I had originally advised, since I expect the recovery in global equity markets to run for several more weeks. This gain more than offsets the miniscule three-point loss on the FTSE 100 short index trade I recommended to try to take advantage of falls in the market the day after the clocks moved forward one hour.
I also advised opening a long trade on the S&P 500 two days prior to St Patrick's Day and closing it out the day after the festival to try to capture the near-1 per cent average rise in the index over this four-day period. The trade didn't work out this year, but the loss was only a small one and the trade has worked a treat over the past five years.
To recap, the S&P 500 was trading at 1289 when London closed on Monday 14 March and was 1296 when Wall Street closed that night. And on Friday 18 March, the index was trading at 1288 minutes after Wall Street opened and closed at 1279 in New York that night. In other words, although UK investors didn't turn a profit they could have got out of the long index position close to break-even. I will continue to recommend this St Patrick's Day trade in the future as on average it has been a major money spinner even if we had to take a small hit this year.
