Previous post: Monday 25th January 2010

This week’s head lines:

  • Bank investors received a shock last week with the announcement of far reaching banking reforms by President Obama. The proposals see the breaking up of large banks into either commercial, deposit taking organisations or those involved in proprietary trading activities.
  • Global stock markets were already nervous before the announcement with investors’ fretting over the possibility of the Chinese economy overheating and policymakers reining–in lending by domestic banks.
  • The recovery in the UK continues to be tortuous with mixed economic data showing parts of the economy doing well such as motor manufacturers but a more subdued outlook for other consumer-led spending.
  • Mark Evans of THS Partners explains why, despite all the worries, equity markets continue to advance and why he feels confident looking ahead.

Obama’s Broadside
The American people’s opprobrium towards Wall Street’s bankers and their excesses manifested itself by voters delivering a pejorative statement to the President in the form of a humiliating electoral defeat in Massachusetts last week. Still smarting, the President himself then stunned equity markets by announcing sweeping reforms of the US banking system, which included the late adoption of the ideas of former Fed chairman, Paul Volker. The reform will mean that commercial banks will be banned from running their own trading desks and owning, investing in or sponsoring hedge funds and private equity groups. In other words, banks will have to split themselves – having to choose between owning an insured depository and owning proprietary trading operations. Announcing the changes, Mr. Obama said “never again will the American taxpayer be held hostage by a bank that is too big to fail”.

The measures, which will need Congressional approval, hark back to the response to the 1929 stock market crash that ushered in the Glass-Steagall Act, separating commercial and investment banking, which remained in law until 1999. The ambition was to lessen the risk of financial catastrophe and it survived in some shape for almost 70 years when a concerted effort by the banks succeeded in getting it scrapped. There is likely to be a re-run today, with professional lobbyists likely to launch a fierce campaign. “We had absolutely no idea this was coming” commented Scott Talbott of the Financial Services Roundtable, a leading Wall Street lobby group. But the President has made his position clear, saying “If these folks want a fight, it’s a fight I’m ready to have”. The return of Mr. Volker, who has been little heard of since his involvement with Mr. Obama and has been highly critical of the banking sector and the invocation of his proposals – the ‘Volker rule’ – surprised everyone.

The reforms set the scene for other Western governments to follow suit, but the response here in the UK is split. On the one hand, City minister Lord Myners, has ruled out Britain adopting similar radical banking reforms. He said he saw the proposals as solutions to “American issues” rather than necessary actions for the UK – amounting to a fillip for the City of London. However, according to shadow chancellor George Osborne, the Conservatives are likely to introduce similar trading curbs for banks if elected. Unsurprisingly, share prices in banking stocks on both sides of the Atlantic took a pounding as investors beat a hasty and disorganised retreat, dragging down the main indices with them. The Financial Times commented that it was clear, with confidence growing amongst politicians that the global economy had been saved, they were seeking ways of paying the ensuing bill and punishing those they perceived as culprits.

Dragon Scorched?
Until the surprise news from America it had been China that had taken centre stage last week, demonstrating its increasing influence on global financial markets. From fears about the potentially dampening effect of domestic bank lending curbs to the unexpectedly strong growth rate it reported, news and views on the world’s third largest economy were very much to the fore. Mid-week, the markets took fright amid fears that China, nervous about inflation, had put a plug in the liquidity that has been fuelling the economic recovery. The country’s chairman of the China Banking Regulatory Commission scared investors with comments about the need to stop asset bubbles, adding that Chinese banks were expected to cut lending in 2010 by about 20%. However, other countries have been relying on China to continue spending to aid their own economic recovery. Next day, official economic data showed that GDP rose by 10.7% in the last quarter of 2009, putting it on course to become the world’s second largest economy behind the US, later this year. However, as The Times commented, the blistering growth figures, although impressive, did not completely dispel concerns over its sustainability, with economists divided. Reflecting these concerns, investors headed for the sidelines, leaving most of the major indices globally lower on the week. Conversely, both the yen and the dollar strengthened as investors sought other perceived safer havens.

See-Saw Recovery
Here in the UK, the path to economic recovery continues to be uneven with positive numbers mixed with less encouraging ones. Data from the Society of Motor Manufacturers and Traders said vehicle production rose by 58.5% in December – the sharpest jump in almost 34 years – helped by the government’s car scrappage scheme. “The significant rise in December vehicle production is welcome news and signals some greater stability across global automotive markets” said the society’s CEO. However, separate figures from the Office of National Statistics showed December retail sales growth that was much weaker than expected at 0.3% – down on the 1.1% predicted by economists. And the chances of a consumer-led recovery seem increasingly optimistic as other ONS data showed that wage growth hit a record low in the three months to November, with average pay in the private sector failing to rise at all.

But one good piece of news came in the form of better unemployment figures – they fell for the first time in eighteen months, with the jobs market bolstered by increasing numbers of people being forced into part-time work, according to ONS data. The number of people working jumped by 99,000 and unemployment fell by 7,000 to 2.45m in the three months to November. Elsewhere, homebuyers rushed to beat the increase in stamp duty at the end of last year and helped push up mortgage lending figures by 14% in December, according to Bank of England figures. But UK public borrowing hit a new high last month, driving public debt to a new record of £870bn – almost 62% of GDP. There was some glimmer of hope as tax receipts rose for a second consecutive month, albeit by a modest 1%. On the corporate front, profit warnings fell sharply in 2009 and economists expect the recession to be declared over this week, according to Ernst & Young – the number of warnings issued fell 37% to a six-year low.

Taking a more global view, economic growth in Europe’s emerging economies will be much stronger than predicted, according to the European Bank for Reconstruction and Development. GDP is forecast to increase from 2.5% to 3.3% – lifting investor confidence in a region hard hit by the global economic crisis because of its dependency on external capital. Whilst the global economy is expected to return to growth this year, expanding by 2.7% according to the World Bank, it will effectively remain in recession as governments withdraw stimulus measures and private demand remains muted. Growth below 3% is deemed to be recessionary according to the IMF. However, the World Bank sees growth increasing to 3.2% for the global economy in 2011, with developing countries leading the way.

Wall of Worry
Since their nadir last March, global equity markets have marched on and after last week’s upset, some investors are concerned that trouble lies ahead for equities and the global economy. Fund manager Mark Evans of THS Partners gives his views on how he sees the global outlook. “Looking back at the last three years, fund managers had two tasks. Firstly to sell before the market collapsed and, secondly, not to sell at the bottom of the market. Whilst we did make a conscious decision not to replace equities we sold in 2007 via takeovers and the like, we could have sold more. However, we offset some of this by not selling at the bottom and indeed became active buyers at very low levels believing the markets had become oversold. Globally we have now achieved some semblance of normality and I think we should view the crisis as a ‘one-step’ down event, which has seen GDP fall sharply by 5% and a one-off spike in government debt. I don’t believe these actions will have a long-term appalling effect, although UK growth in the medium term will be slow.

“Whilst a familiar message, we still believe equities are cheap – they are the unloved asset class following a 15-year de-rating. The recent takeover bid by Kraft for Cadbury’s illustrates the potential upside for equity re-rating: the stock was £5.50 before the bid and finally agreed at £8.50 representing a 50% uplift. Today, many of the companies we own continue to trade on single, sometimes just into double-digit price earnings ratios. It is perfectly normal for growth shares to trade on a p/e of 20 and income stocks on a p/e of 15. The UK market trades on a forward p/e of 13 and this year the earnings of European companies are expected to increase by 38% and by 28% in 2011. Companies are much less indebted than they were, but overall people remain sceptical about the ability of the stock market to continue to rise.

Within the portfolio we continue with our thematic approach and hang on to our long-term ideas like oil in safe places, which has evolved into clean energy. Food is a relatively new theme which will play-out in the huge increase in future demand as the emerging economies develop and we own Bunge, for example, which is the world’s largest potash producer. We are back looking at Japan once more – everyone is avoiding it and the stock market has languished over the years, but they are still good at many things and have a good work ethic. The yen is too expensive as is the euro and the pound is too cheap, so we have hedged our currency exposure back into sterling where we expect to book an additional profit.

People continue to worry about a whole host of things, which I think is actually encouraging. They worry that the markets have already recovered, budget deficits, global imbalances, inflation, deflation, low growth, anti-business sentiment, UK elections and a hung Parliament, cooling of China, overheating of China, the Chinese economy falling off a cliff and Japan finally running out of road. This is the wall of worry that stock markets have to climb, but it is healthier because the markets are pricing-in these concerns as they go along and are not simply rising on the back of hopes for a blue sky, sunshine scenario which is unlikely to materialise. So that’s why we are confident about the outlook for shares”.

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