World’s largest economy spends its way to recovery

In this week’s bulletin:

  • Equity markets regain upward momentum despite eurozone’s political and economic setbacks
  • UK economy suffers ‘double-dip’ recession
  • ECB chief calls for ‘growth compact’ to boost recovery prospects
  • Spain continues to feel economic pain – unemployment rockets
  • World’s largest economy spends its way to recovery
  • Wall Street boosted by record corporate earnings – Apple’s results delight investors
  • Investors should maintain their ‘buy and hold’ strategy for UK equities
  • Fund manager Nick Purves of RWC gives his views

 

Market Eye

  • Equity markets regain upward momentum despite eurozone’s political and economic setbacks
  • UK economy suffers ‘double-dip’ recession

After a wobble at the start of last week following the surprise first-round French presidential election results, financial markets managed to regain their poise, allowing investors to reflect on what a change in government might mean for the eurozone longer term. Sentiment was helped by a strong flow of first-quarter corporate earnings results in the US, many of which beat analysts’ expectations and reassured the markets that, despite numerous headwinds, businesses continue to maintain their margins. Not that the week passed without any upsets: news that the UK had slipped into a ‘double-dip’ recession, whilst received with disbelief by some, was nevertheless unnerving. Spain, too, joined the EU recession club; and received another blow to confidence when credit rating agency Standard & Poor’s cut the country’s sovereign credit rating by two notches, predicting that the country’s recession would continue into 2013. But despite this less-welcome flow of news, markets remained stoic with most major equity indices making gains, led by Paris and Wall Street. Oil also resumed its upward trend following two weeks of decline, with Brent crude coming within a whisker of $120 per barrel, whilst gold regained some of its lustre with the price of a troy ounce rising to $1,664. So, by the end of the week, markets managed to close in a far more orderly fashion than they started.

 

Eurozone needs some zoom

  • ECB chief calls for ‘growth compact’ to boost recovery prospects
  • Spain continues to feel economic pain – unemployment rockets

“Spain is undergoing a crisis of enormous proportions”

José Manuel Garcia-Margallo, Spain’s foreign minister

Whilst the eurozone may be the world’s third-largest economic region, growth remains disparate, with the likes of Germany enjoying a strong recovery and low unemployment whilst Greece, Spain et al struggle. The latest unemployment data from the Instituto Nacional de Estadística, the Spanish national statistics institute, was truly shocking: it showed that almost 25% of the country’s workforce is unemployed, with half of young people aged under 25 without work. Spain’s foreign minister, Mr Garcia-Margallo, said the figures were “terrible for everyone and terrible for the government” but reassured markets by making it clear that Madrid was not abandoning its austerity plans. Spain’s dire economic data come amid a Europe-wide debate about whether government austerity imposed to cut budget deficits is threatening growth prospects, highlighted by unexpectedly weak eurozone ‘flash’ purchasing managers’ surveys which showed slowing German manufacturing activity.

Mario Draghi, the European Central Bank president, called for the region to adopt a “growth compact” to boost the eurozone’s economic prospects – underlining the depth of concern about recovery among eurozone officials. Many economists argue that, in the case of Spain for example, austerity threatens to be self-defeating as a heavily indebted private sector (with a debt-to-GDP ratio of 300%) is now trying to deleverage while the public sector cuts back savagely. It is a similar argument put forward by political opponents to austerity here in the UK. That is, cutting central government expenditure sharply, alongside higher taxes and stubbornly high inflation, means households have little if any scope to increase their discretionary spending, thus holding back recovery. Not that a dose of austerity is always bad, as was signalled this week by Ireland’s plan to return to the international bond markets and exit its international bailout programme by the end of next year. Ireland has earned the nickname of the “poster boy for austerity” for meeting all its bailout targets and implementing tough reforms while retaining political stability. Markets will no doubt be hoping that this becomes a trend amongst the eurozone’s peripheral members.

 

The Big Apple

  • World’s largest economy spends its way to recovery
  • Wall Street boosted by record corporate earnings – Apple’s results delight investors

Whilst Europe may be struggling, across the other side of the Atlantic the world’s largest economy continues to gain momentum. Not that Europe’s headwinds do not pose a potential problem; but unlike the EU, America has not embarked on a programme of austerity, preferring instead to carry on spending its way out of recession. And there is much evidence that US recovery is on course. Shipments of ‘core’ capital goods – excluding volatile aircraft and defence equipment – rose 2.6% in March. Manufacturers are reporting surprisingly good earnings figures for the first quarter and are optimistic about the rest of the year, despite higher energy costs. Wall Street recorded its best week in a month or more last week, as Apple and Amazon spectacularly surpassed expectations in their respective earnings reports. The two companies join other business such as IBM, Alcoa and J P Morgan which have similarly surprised on the upside. The news helped the S&P 500 to reclaim the 1,400 mark for the first time since early April, which itself was a post-financial crisis high.

Elsewhere within the economy, consumer debt levels are dropping so that financial obligations – such as mortgage and credit card payments – which soaked up 14% of income in 2007, now account for only 10.9%, leaving consumers with more money to spend. Even the moribund housing market is showing some signs of life, albeit from a low level, with average house prices up marginally for the first time since July 2007, according to the Federal Housing Finance Agency. For good measure, investors were pleasantly surprised when Ford Motor Company’s securities regained their investment-grade status, despite narrowly avoiding bankruptcy back in the midst of the financial crisis in 2008. So is it all blue sky and sunshine? Chairman of the Federal Reserve, Ben Bernanke, remains on full alert and is taking nothing for granted following his comments last week that the Fed’s monetary committee meeting was “a little vaguer than you’d like”, thus leaving the door open to further stimulus in the form of QE3.

 

Buy British

  • Investors should maintain their ‘buy and hold’ strategy for UK equities
  • Fund manager Nick Purves explains why

News that the UK economy has fallen back into recession should not be seen as a signal for investors to sell or switch their fund holdings. To the contrary, past experience shows that the performance of equity markets – and funds – is not correlated with economic growth. Indeed, the market’s reaction to the recession news was very telling – insofar as there wasn’t one; share prices rallied throughout the week. The case for continuing to hold and indeed buy UK equities is compelling. British companies have a price-to-earnings ratio of around 10, compared to a twenty-year average of almost 17; and compare very favourably to European and American stocks which trade at more expensive levels. The other crucial point is that UK equities tend to generate a high proportion, in excess of 70%, of their earnings from overseas. This means that while domestic growth is likely to remain weak, their foreign earnings are an effective way to import growth, particularly from emerging markets. Good examples are companies like Unilever, where just over 50% of its earnings come from the likes of China and India.

Nick Purves, a UK equity manager with RWC, helped put matters into perspective. “As you know, we are bottom-up investors and would never build our portfolio around a view of macro economic trends which we believe are very difficult to forecast. We would, however, make two general points. Firstly, the companies represented in the UK stock market are internationally diverse and these days have a relatively small dependence on the UK economy. Secondly, historically it can be observed that value strategies, tend to suffer just prior to recession but have often fared better once the recession is formally recognised. This is a function of the fact that markets tend to look forward six to twelve months and thus at the trough of a recession, prices are already starting to discount the recovery. So if you invest in my portfolio, your capital will be invested in high-quality companies with strong balance sheets, strong business models, and high levels of cash flow which are well able to weather any economic slowdown.”

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