In this week’s bulletin:
- Global equity markets staged a recovery for the second week as fears over the eurozone took a back seat despite inter-bank liquidity problems for countries like Spain.
- Poor economic data from the US was offset by better data from the eurozone where the region’s growth is at its fastest for twenty years.
- Japan announced its intention to introduce austerity measures despite calls from President Obama for countries to maintain their stimulus policies.
- Here in the UK inflation fell alongside public borrowing in May but so too did consumer confidence although both the residential and commercial property markets continue to head upwards.
- Fund managers Stuart Mitchell and Richard Oldfield share their respective views on the outlook for equities and economic recovery.
Global equity investors chose to shrug off lacklustre economic data last week, encouraged by signs that tensions over the eurozone debt crisis were easing. The boost came in the form of a statement by European regulators, who said they would reveal details of European bank stress tests by the end of July. A successful Spanish government bond auction mid-week also gave markets a fillip. However, potential problems still lurk below the surface it seems, as the short-term debt markets – interbank lending – have effectively locked out Spanish banks, causing potential liquidity problems, according to The Times. However, Chancellor Merkel was quick to point out that Spain could tap into the €750bn eurozone rescue package – “The mechanism can be activated at any time” she said. Traders also highlighted the fact that it is not just Spain that has been marginalised: short term debt markets are effectively closed to the banks in the peripheral economies of Ireland, Portugal and Greece too. The latter suffered the ignominy of a further rating downgrade of its bonds to ‘junk’ status by Moody’s – much to the annoyance of Brussels.
On the economic front, worries about the global economy resurfaced following weaker than expected data from the US, with the Economic Research Institute saying that its weekly leading index – a gauge of future economic growth – had fallen to a 45-week low of 122.5. Earlier in the week, data released showed US housing starts had dropped unexpectedly sharply in May, down 10%, as the homebuyer tax credit was withdrawn. This came alongside a rise in jobless claims and a fall in factory growth. But investors took the news in their stride, mollified by news that eurozone industrial output had soared in April at its fastest rate in two decades – this helped dispel worries that the region might slow sharply because of the sovereign debt crisis. By the end of the week, leading indices had all notched up gains, with Europe leading the way and enabling London’s blue-chip FTSE100 to close at 5,250 – helped by a rally in BP’s shares. The oil behemoth announced, under pressure from the Obama administration, that it would suspend its dividend to the end of the year and set aside an initial $20bn fund to cover the cost of the Gulf oil disaster.
On the international front, Japan caused some consternation when its relatively new government announced that it was going to renege on its election promises – generous child benefits, reduced motorway tolls and aid for farmers – and impose an austerity discipline on its public finances. The country has, surprisingly, one of the most strained public balance sheets in the world – even surpassing Greece: its new Finance Minister, Yoshiko Noda, is faced with defusing the country’s explosive 200% ratio of debt to GDP, as noted by The Times. Previous Finance Ministers have not been known for being tough, so in describing Japan’s situation as “severe” Mr. Noda is setting the scene for some unpopular measures. The timing of the government’s announcement comes just before the G20 meeting in Toronto this week, where the leaders of the world’s largest economies will gather to agree future policy.
The timing of Japan’s announcement coincided with a call from President Obama for governments not to cut back on stimulus spending – he said that the highest priority must be to “safeguard and strengthen the [global] economy”. Mr Obama also said that “market-determined exchange rates are essential to global economic vitality”. This was seen by observers as further criticism of China’s policy to refuse to allow the yuan to rise in value, which would most likely act as a demand stimulus for Chinese consumers as imports would be cheaper. However, in a surprise move over the weekend, The Sunday Times reported that China has sent a signal that it may, after all, allow a more flexible exchange rate for its currency by ditching a two-year peg to the dollar. If so, it would be positive for international markets by assuaging concerns about rising tensions between the US and China. The statement from the People’s Bank said “The central bank has decided to proceed further with the reform of the renminbi”.
Here in the UK, lots of things are going down it seems – growth forecasts, inflation, government borrowing and consumer confidence are heading south. Some of this is clearly good news – public finances in May improved as data showed that the government borrowed less than expected, implying improved tax receipts on the back of a growing economy. Inflation also ticked down more sharply than expected last month – from 3.7% to 3.4% – prompting economists to suggest the peak in price pressures had passed. The Financial Times said this seemed to offer support for the Bank of England’s view that the current level of high inflation will be short-lived. On the growth front though, the newly established Office for Budget Responsibility, headed by Sir Alan Budd, revised downwards UK growth forecasts just ahead of the Budget, implying potentially greater cuts in spending by the government than those already planned. The OBR cut earlier Treasury estimates made under Alistair Darling from between 3%-3.5% to 2.6%.
On the consumer front, Britain plunged into gloom last month, according to the Nationwide’s index of consumer confidence as fears over the economy, tomorrow’s Budget and the eurozone crisis overshadowed the creation of a new government. According to the index, confidence slipped ten points to 65. However, there was room for cheer – house prices are still edging up and the demand for mortgages rose by 7% in May, according to the Council of Mortgage Lenders, although it described the market as subdued. And it’s not just the residential market that is recovering. The demand for commercial property continues to grow following the sector’s dire performance during the crisis. Last week there was further evidence of recovery as one of the world’s largest sovereign funds announced a series of deals it had agreed for some of London’s trophy properties. The Qatari Investment Authority, which already owns Harrods, is set to take over Songbird, the listed owner of Canary Wharf and, according to The Times, bids are expected on the Savoy Hotel and Grosvenor House. Foreign interest has been one of the key drivers behind rising prime property prices, particularly in London and the South East.
The recent problems in the eurozone have made investors wary of owning European equities, but as witnessed last week, a change in sentiment can have a swift and positive effect on share prices following recent weakness. European equity fund manager Stuart Mitchell acknowledges Greece’s problems but remains positive on the case for equities. “There is always geopolitical risk in investing. Greece is a concern to me but I don’t think one should underestimate the determination of Germany and France to maintain stability – they have been hugely influential during the recent crisis but have demonstrated great political will and both can bear the cost of the recent support package. From a corporate view point, business profits are still rising yet valuations are still relatively low – latest figures show many companies trading at only 10 times earnings compared to a long-run average of 15. I believe shares are still very cheap when compared to bonds and cash. I do own financial stocks and they account for around 25%, but these are mostly insurance companies, such as Swiss Re and Allianz. Within the portfolio I have consciously been reducing risk following the strong rally, adopting a more defensive approach as quality stocks have lagged behind and represent a good buying opportunity. I aim to be 100% invested for the foreseeable future”.
Taking a more global perspective is Richard Oldfield who feels that, whilst there are still potential issues to be addressed, careful stock picking can potentially unlock intrinsic value which may not be priced into a company’s share price. “I am a long-term value investor which means I try to keep a distance from daily price movements – it can lead to very short-term decision making and knee-jerk reactions. In the US, cash flows are equivalent to 22% of market cap which is very high and a result of a strong recovery in profitability. If one uses cash as a percentage of balance sheets then the current level of 11% is the highest since 1968. When I look at the portfolio, valuations are modest – shares that trade on a price-earnings ratio of around 10 offering good upside of around 28% relative to the market.
I like to buy quality businesses at a discount to the main market. I have recently bought Fiat which, whilst not without challenges, is a very diverse business – it owns Ferrari and has a 25% market share in Brazil – and effectively trades at a 50% discount to the sum of its parts. My exposure to Japan is 25% which includes companies such as Canon and Fanuc, a robotics business – these are cash-rich businesses and at some point will enjoy a re-rating. I’m cautious on China as a lot of good news is already priced-in. In the US, I own Johnson & Johnson, a high quality company where for the first time since 1985, the earnings trend line has moved above the share price, which is a significant buying signal. D R Horton is a US home builder and well-placed for recovery – its significant cash flows have enabled them to reduce their stock, hoard cash and make opportunistic acquisitions as competitors fail. So today I think there are some huge opportunities to buy good businesses at a discount to the broad market and then, one needs to be patient”.
Of course, equities are just one asset class and for some investors recent volatility has been, understandably, rather disconcerting which has made them wary of investing. The proven way to manage both risk and volatility is to ensure one’s portfolio is diverse by asset class, geography and fund manager style.
Unsurprisingly, there is much trepidation about the contents of Chancellor George Osborne’s Emergency Budget, which is likely to contain a cocktail of tax rises and spending cuts. Capital Gains Tax has proven to be very controversial as potential changes may hurt those who want to be financially independent and have thus been prudent. We shall know the outcome by the close of tomorrow and along with it the initial reaction of the financial markets but as ever, it’s important to remember that, as Richard Oldfield points out, investing is a long-term business.