In this week’s bulletin:
- Increasing economic evidence that the US economy is at last set to take-off engendered a positive tone for markets last week.
- Also helping sentiment were comments from US Fed chairman Ben Bernanke who saw the chances of a double-dip recession fading.
- Here in the UK the economic outlook is less clear but a report from the Ernst & Young ITEM Club said after sluggish growth this year the UK economy should surge next year.
- China sought to take steps to cool its rampant property market which stormed ahead in the last year and raised concerns about overheating.
- There was unexpected news on Friday when the SEC announced that it had charged US investment bank Goldman Sachs with fraud related to sub-prime loans.
- UK equity income manager Nick Purves of Schroders shares his view on the outlook for equities.
Ready for Take Off
It seems that at long last the world’s largest economy is set to take off, unlike most of Europe’s airlines which were grounded last week by a volcanic ash cloud from Iceland, causing travel chaos. Unsurprisingly, airline stocks took a tumble as investors decided to check out and move on to opportunities elsewhere. On Wall Street, shares enjoyed a surge early in the week, buoyed by strong corporate results from the likes of Intel and JP Morgan and positive noises from Ben Bernanke, chairman of the US Federal Reserve, whilst giving his testimony to Congress. “It looks like we’re on a path to moderate recovery and that the risk of a double-dip [recession], while certainly not neglible, is certainly less than it was a few months ago” he said. While stressing that it would take a “significant amount of time” before the recovery had an impact on the job market and there was a risk that unemployment would stay close to 9.7%, Mr. Bernanke’s comments boosted the markets.
The Fed chairman’s comments coincided with data showing that US retail sales were some 1.6% higher in March compared to February – far higher than economists had expected. Barclays Capital commented “The pick-up in consumer spending is crucial for creating positive momentum in the economy and making it a sustained recovery”. Adding to the mood of optimism, a report from the US Labor Department pointed to ‘core’ inflation remaining relatively weak which means that the Fed will have plenty of freedom to keep interest rates at record lows during the coming months. There is evidence too that surging profits may be giving businesses the confidence to hire again, according to Gus Faucher at Moody’s Economy, who believes the economy has been coming out of recession since last summer. He also pointed to the fact that unemployment is a lagging indicator and that it would be some while before sufficient momentum was gained for the recovery to really take off.
However, the economic figures continue to see-saw and the largest cloud hanging over the economy remains the housing market where there are still a lot of foreclosures in the pipeline. Last week, official figures showed industrial production rose by a meagre 0.1% – much less than expected – and the University of Michigan’s consumer sentiment index fell in March to its lowest point since last November. Unemployment remains the biggest drag on the consumer and this figure too surprised economists, jumping by 24,000 last week compared to an expected fall. So whilst it is clear that America may be on the up, its consumers are not as yet enjoying the party.
For the UK the outlook is, according to the respected economic forecasting group Ernst & Young ITEM Club, less certain. It seems that weakness in the consumer sector, a stalling housing recovery and falling business investment will hold UK growth back, with the economy struggling to grow by 1% this year. However, the group is forecasting that the economy will surge next year and into 2012 on the back of exports and foreign invest growth by British private companies. “There are good reasons to be optimistic about exports and overseas demand. The competitive pound provides the carrot and the weak home market provides the stick” said the Club’s chief economist Peter Spencer. UK GDP figures for the first quarter are due out this week and analysts are expecting a figure of 0.4% although few would be surprised if the Office of National Statistics came in with a lower, initial figure which it then subsequently revises said The Sunday Times. On the consumer front though, people are still buying albeit with some caution – total retail sales in March rose at their fastest rate since last November, according to the British Retail Consortium.
China goes Cool
It seems that the world’s second largest economy is losing its enthusiasm for a red-hot property market and the country tried to batten down the booming sector last week, only hours after announcing GDP growth of 11.9% in the first quarter of the year. The massive rise in the country’s growth is stoking fears that the economy could be overheating – attention has specifically been focused on the property sector where prices have gone into overdrive. According to The Times, property prices in China’s major cities rose by 11.7% last month – their fastest rate in nearly five years. In response the authorities have introduced new rules requiring a 30% down payment on larger homes and 50% (up from 40%) on all second-home purchases.
The GDP growth provoked an immediate effect on the region’s stock markets, with investors swayed about the prospect of runaway Chinese demand for raw materials – crude oil was particularly firm, moving above $86 per barrel. One potentially positive outcome of the growth figures may be that China will feel more comfortable about allowing its currency to rise. The Financial Times pointed out that US politicians and many economists argue that Beijing deliberately undervalues its currency to boost its exports at the expense of jobs and exports of other countries that run large trade deficits with China. News that growth in China’s exchange reserves had slowed sharply in March gave rise to speculation that this would take the pressure off Beijing to revalue the renminbi. Credit Suisse’s chief China economist commented “This will certainly help Beijing’s argument but regardless of the monthly deficit and slowing reserves the US will keep up the pressure because a lot of the debate is motivated by political considerations on Capitol Hill”.
A Week in the Markets
Meanwhile, back in the equity markets, investors enjoyed a positive start to the week despite the ongoing rumblings of Greece’s economic woes. Greek government bonds were very volatile as the country appeared to move ever closer towards activating a support package agreed by eurozone nations and the IMF – yields moved up once more as investors became increasingly nervous. The positive news from corporate America coupled with less pessimistic comments from Ben Bernanke enabled US equity markets to hit 22-month highs, with the S&P500 index scaling the 1,200 level, boosting other markets in turn. Unfortunately the positive sentiment didn’t quite make it to the end of the week.
Investor risk appetite evaporated on Friday as shock news emerged that the US Securities and Exchange Commission (SEC) had charged the US investment bank Goldman Sachs with fraud related to sub-prime mortgages. “For one of the most highly-respected banks in the world to be hit by this news is going to have serious ramifications as fear sets in that they may not be the only one to have misled investors” was the view of one analyst at Capital Spreads. The net result was that most global equity markets ended the week where they began as they relinquished earlier gains.
Outlook Remains Positive
The huge rally in share prices witnessed in the last year or so hasn’t dented the enthusiasm of one of the UK’s star equity income managers. Nick Purves of Schroders is a value manager who often takes a contrarian view to other investors and last week he shared his current views.
“Last year’s strong recovery in the equity market reflected investors’ views that economic recovery would ultimately come through. Whilst the economy has improved, this is still a worrying time for equity investors – people are concerned about a whole host of issues such as double-dip recession, budget deficits, inflation and a hung parliament to name but a few. Whilst there may be numerous issues to collectively worry about the important thing to remember is that the stock market is a discounting machine. On a daily basis it prices in the ramifications of the latest economic data, geopolitical issues and crucially, the outlook for corporate profit growth, which is what ultimately drives share prices. And corporate earnings have surprised on the upside over the last few months, with companies benefitting from the swift and often savage cutbacks on costs that were made during the crisis.
Despite the hugely strong rally from last March’s low point, the UK market is not expensive when measured on an historical basis. The price-earnings ratio is a simple but useful measure of a company’s average earnings over the last ten years relative to its share price. Looking at the UK market as a whole, its p/e is currently around 15 compared to an average of 16 so I would say that the market is fairly valued. Now within the market there are sectors and stocks which are expensive to me but many others that are relatively cheap, so this is a good environment for stock pickers such as me to capture these anomalies.
As a value investor I am seeking out companies who have the ability to pay dividends going forward, so balance sheets are crucial. So, as an example, I don’t like National Grid because it’s a capital intensive business with no foreseeable free cash flow over the next five years. Conversely, AstraZeneca has huge positive free cash flow and has no net debt, yet both companies trade on a similar p/e of 10 and yield 5% – what I am looking for is a re-rating of AstraZeneca’s share price to reflect this situation. Within the portfolio there are other stocks in a similar position, so I own telecom stocks such as Vodafone along with banking stocks, which I view as lowly valued but fundamentally sound companies and will probably end up being over-capitalised following the crisis.
So, looking ahead, I am positive on the outlook – corporate balance sheets are in their strongest ever position and free cash flow yields are the highest ever, which in my view augurs well for those investors prepared to take a medium to long-term view on equity investing”.