A monthly round-up of global markets and trends
INVESTMENT REVIEW - POLITICAL LEADERSHIP IN THE SPOTLIGHT
Uncertainty about the global economy should begin to lift in November with the US presidential election and confirmation of China's new political leadership marking an important new phase for financial markets.
World
Political uncertainty, combined with mixed corporate earnings and poor company earnings guidance, has meant that markets have generally been choppy and range-bound for a while, awaiting a new sense of direction. In the US, some of the uncertainty is now likely to have lifted as Barack Obama and his administration prepare for another four years in office. The hope is that the landscape will be clear enough for companies to begin investing the cash on their balance sheets and provide the US economy with another potential avenue for growth.
The outlook in Europe meanwhile remains as cloudy as ever. The European Central Bank's (ECB) words of support have helped lower bond yields for the most indebted governments and stabilised equity markets, but political tensions have been growing again and important decisions about Spain, Portugal and Greece, which all need bailouts or bailout extensions, are back on the agenda. Although the US election has kept the eurozone off the front pages for a few weeks, the deteriorating economic backdrop in Europe and continued political brinkmanship may yet return to worry investors, despite the attractive valuations of many European stocks.
With the impact of liquidity injections by central banks waning, investors may be looking to the US and China to provide evidence of a renewed impetus to global economic growth. Bond prices have meanwhile slipped back in apparent anticipation of such a modest improvement.
UK
The 1% rise in GDP in the third quarter exceeded expectation and helped lift the UK economy out of a technical recession. While the figures come as a welcome change of pace, most of the gain in output is attributable to temporary factors. It is too early to be sure that this marks the start of a decisive uptick in growth.
The summer Olympic Games gave a boost to services, which in turn helped to push jobless claims down to their lowest level in more than a year. The number of people employed in the UK has risen to the highest level since records began in 1971. The sharp contrast between the trends in employment growth and the level of output in the economy has puzzled economists and policymakers. While employment has reached record levels, according to the Office for National Statistics, productivity remains around 4% below pre-recession levels, limiting the growth potential of the economy. The question for the Monetary Policy Committee (MPC) is what to do next? Minutes from the most recent MPC meeting show the focus of discussion has shifted to whether further quantitative easing (QE) in its current form will do any good.
Although inflation has fallen to just above the Bank of England's 2% target level, energy price increases announced recently are likely to moderate the impact on disposable incomes. Early reports suggest that the funding for lending scheme launched in June is beginning to yield positive results in the mortgage market, but the MPC may be forced to implement even more unconventional policy if it is to reach the wider economy.
The FTSE 100 stock market index is highly skewed towards the mining and energy sectors, which have proved vulnerable to the continued global slowdown. Investors have been finding better value in companies further down the market cap scale. Both midcap and small cap shares have comfortably outperformed the FTSE 100 stock market index over the past three months.
US
As the dust begins to settle on the presidential election, recent data shows that the US economy remains on an improving path. Third quarter GDP grew at a more healthy annualised rate of 2% with a solid pick up in consumption growth. There are signs that the improvements in the labour and housing markets are beginning to feed through into consumer confidence which has risen to a five-year high. Yet confidence among US corporations remains low and the absence of 'animal spirits' is continuing to limit the economy's potential to grow.
While corporate earnings have generally held up well, expectations remain subdued. A number of prominent US companies have offered poor forward earnings guidance, hindering equity market performance. Given the uncertain growth outlook, more analyst downgrades are expected in the final quarter. However, now the elections campaigns have come to a conclusion, the political landscape should become somewhat clearer, notwithstanding the prospect of more bipartisan wrangling in Washington. Provided that the President and Congress can reach an early deal to resolve the looming 'fiscal cliff' with an agreement on new tax and spending measures, investment prospects can only improve.
Our view is that a political resolution is likely to be achieved, paving the way for a renewed wave of corporate investment. The US remains ahead of the rest of the developed world in deleveraging after the credit excesses of the pre-recession period. Now Barack Obama remains as president, it is clear that Ben Bernanke, the chairman of the Federal Reserve and architect of its successive programmes of QE, will remain at his post for at least another 12 months and the central bank is likely to persevere with its loose monetary policy for the foreseeable future.
Europe
The ECB's promise to do "whatever it takes" to keep the euro in existence has so far succeeded in restoring its credibility as an effective force for fighting the disintegration of the single currency. Sentiment towards the region has improved with US money market funds increasing their European exposure, and bond yields in Spain and Italy all declining to more manageable levels. The ECB's plan to purchase government debt under its outright monetary transaction programme has succeeded in reducing borrowing costs for the peripheral countries without the need, so far, for actual purchases to be made.
However, the economic climate continues to deteriorate, as the region slips further into recession, compounding the pressure on government finances. While company earnings forecasts have been downgraded to reflect the lower growth environment, they appear to have been already factored into investor expectations, with quality European companies with emerging market exposure trading at large premiums to firms that operate within the eurozone itself.
The greatest danger for the eurozone remains political, as governments across the region wrestle with unappetising choices in a fragile political climate. An official request from Spain for a bailout remains probable, despite the Government's resistance to agreeing further reforms and austerity measures that are the necessary prerequisite for a combined bailout and ECB bond purchases. The Greek Government meanwhile faces a critical test this month in forcing through yet another round of unpopular cuts and tax increases to justify its request for the latest round of bailout funding from other eurozone states. The Greek economy continues to contract at an alarming rate.
Asia
The Japanese economy could be heading for its own fiscal cliff as a political gridlock threatens to dry up the funds needed to finance the Government's budget deficit this year. A bill, that if passed would allow the Japanese Government to borrow around $480bn, will be supported by opposition parties only on the condition that Prime Minister Yoshihiko Noda calls a general election – a contentious issue with his ruling Democratic Party lagging in the polls. Failure to reach an agreement by the end of November could mean vital bond auctions are suspended, resulting in the Government running out of money. Appetite for Japanese equities remains low, with the yen continuing to appreciate against all major currencies, impacting the countries large export firms. Honda, one of Japan's largest companies, has cut its annual profits forecast as demand and growth in the global economy remains low. Although the Bank of Japan has implemented further monetary stimulus, including the proposal to offer unlimited loans to banks at low interest rates in a bid to boost credit demand, reigning in the runaway currency is the most urgent priority for policymakers.
The continued slowdown of the world's second largest economy was confirmed when China's third quarter GDP growth fell to 7.4%. Although this was the seventh consecutive quarterly decline in growth, a recent increase in key domestic economic indicators at least holds out the prospect that the third quarter marked the bottom of the slump. Industrial production, retail sales and fixed asset investment all exceeded expectation in September and point to a modest recovery in the coming months. Clarity about the direction of the Chinese economy should improve after the planned changeover in leadership this month. The focus of the new ruling group of the Chinese Communist Party will be to continue the transition from an export-driven to consumption-led economy without triggering social unrest. Chinese equity markets remain attractively valued should growth rates stabilise or improve. If the new leadership succeeds in implementing financial market reforms and reducing corruption, it could well produce greater flows of money into Chinese equities both domestically and from overseas.
Important note: This article summarises Smith & Williamson Investment Management's current assessment of recent developments in the global economy, but our investment managers have discretion to tailor individual portfolios to the specific needs and risk profiles of clients rather than follow a specific model.
MARKET HIGHLIGHTS
MARKET RETURNS
Note: All values as at 1 November 2012. Sources: FTSE, Thomson Reuters Datastream, Bloomberg. FTSE International Limited (FTSE) © FTSE 2012. FTSE® is a trade mark of the London Stock Exchange Group companies and is used by FTSE International Limited under licence. All rights in the FTSE indices and/or FTSE ratings vest in FTSE and/or its licensors. Neither FTSE nor its licensors accept any liability for any errors or omissions in the FTSE indices and/or FTSE ratings or underlying data. No further distribution of FTSE Data is permitted without FTSE's express written consent
INVESTMENT Q&A – HUNTING FOR VALUE IN EUROPE
European equities, as measured by the EuroStoxx 50 index, have risen by 20% since their low point in the summer of 2012, although this has only taken the level of the index back to its earlier peak level in March this year. Mark Pignatelli, manager of the Smith & Williamson European growth fund, explains what lies behind this volatile performance and how his fund seeks to profit from it. Mark joined Smith & Williamson in 2008 as head of European equities after an earlier career at Barings and Schroders. These are his personal views.
European equities have massively underperformed since the global credit crisis? Why such an extreme reaction?
A 100% chance of losing 10% of your money represents exactly the same risk as a 10% chance of losing 100% of your money, but clearly you can recover from 90 whereas you cannot from zero. Therefore the perceived tail risk of a collapse in the single currency has caused a wholesale stampede out of European equities by professional and private investors alike.
Many people might say that was a rational response to the uncertainty over the fate of the euro. Are they wrong?
It is understandable at an aggregate market level, but the interesting dynamic behind the sell-off has been the indiscriminate nature of it. This has resulted in extreme levels of intra-market valuation discrepancies. Both good and poor quality companies have been penalised in much the same way. This is typical of markets at their most extreme. The silver lining is that such moments can create an exceptional opportunity to buy good stocks at bargain basement prices – assuming of course that you have the ability to separate the wheat from the chaff!
What, if anything, has changed since the summer to justify the market's rise?
After three years of crisis, Europe now has begun to put in place the two things that are required to make it a fully functioning sovereign state, in the sense that the US and UK are sovereign states. One is that the ECB, after years of sticking to a narrow anti-inflationary mandate, has publicly committed itself to supplying sufficient liquidity to keep the region's economy moving – a necessary development in a world characterised by shrinking balance sheets.
The second is that Europe's political leaders have finally agreed on a mechanism to recycle surpluses from the richest countries in the eurozone, such as Germany and the Netherlands, to those, such as Greece, Portugal and Spain, with the biggest deficits. This is the same kind of transfer system as the UK and US operate between their richer regions and states. This second function has been constitutionally enshrined for the first time in the articles of the European Stability Mechanism (ESM), the permanent bailout fund which came into existence at the start of October.
What kinds of share have done best since the market turned?
Value stocks and financials have led the market rally. These are the same sectors that were abandoned with most alacrity over the previous two years. The aversion to financial stocks, whose fate is obviously closely tied to that of the euro as a viable currency, is more understandable than the shunning of value stocks, which I define as shares which are cheap on fundamental measures such as dividend yield, price-earnings ratio and so on.
Will the rally last?
In my opinion, the answer to that is yes. I believe that we are at the beginning of a meaningful bull market in European equities. All the conditions that are needed for an enduring rally seem to be in place: terrible investor sentiment, extreme absolute and intra-market valuations, low ownership by professional investment institutions and an improving fundamental picture.
Of course nothing about equity markets is ever 100% certain and investors need to be sure that they wish to take on the still not insignificant risks involved. As the manager of a fund whose mandate is to own European equities, I can only report my honest conviction that current market conditions are the most favourable for European equities we have seen since the onset of the global financial crisis in 2008.
What approach are you taking in your fund to investing across the region?
The Smith & Williamson European growth fund takes a contrarian stance on this issue. Most investors, according to the analysis we have done, hold lots of extremely overvalued defensive stocks and have little in the way of entrepreneurial spirit in their portfolios. My fund has a growth mandate and therefore the portfolio is overweight in shares that we think have the greatest growth potential.
Where have the most striking valuation anomalies developed in your view?
'Value' as an investment style is one of the strongest long- term drivers of outperformance (buying stocks which are reporting positive earnings per share revisions is another). Buying value stocks has seldom resulted in more than one year of drawdown or underperformance. Yet in both 2010 and 2011 value was the worst performing investment style in Europe and it is still marginally in negative territory this year. Therefore my belief is that the best returns will accrue to those who buy value and avoid comfort zones.
Can you give some examples of the companies your fund owns – and why?
Smurfit, the Irish packaging company, has a free cash flow yield of nearly 20%. Dufry is a Swiss duty free shop which is currently trading on a PE of 13x. According to my analysis, that does not reflect its longer-term growth potential. Many European banks are meanwhile priced at 0.6x their book value; we own some in our current portfolio. As with all funds, you look to moderate the risk of the individual holdings by diversifying across a range of companies, sectors and countries.
What risks remain for investors looking to increase their European exposure?
Despite the positive market reaction to the ECB's recent announcement that it will do "whatever it takes" to save the euro, the eurozone is not out of the woods for certain yet. The economic crisis in Spain remains a concern. You have to differentiate between a woeful social backdrop for a country (which is clearly unfortunate) and whether these socio- economic issues have any direct impact on the pricing of risk assets. Looking forward, my belief is that the problems have been ring fenced – from a stock market perspective – by the actions of the ECB and the introduction of the ESM. Time will tell whether that confidence is justified.
Important note
The opinions and views expressed here are those held by Mark Pignatelli at the time of publication and are subject to change. His investment style is a contrarian one and these views may not represent those of Smith & Williamson as a firm. Our investment managers have discretion to tailor individual portfolios to the specific needs and risk profiles of clients rather than follow a specific model or fund portfolio. This material is for information purposes only and should not be taken as or construed as a recommendation or advice relating to the acquisition or disposal of investments.
FIVE AND TEN YEAR RETURNS
For long-term investors what matters most are the returns they achieve over the full course of the business cycle, adjusted for risk. The charts below show the performance of country stock markets over five and ten years. The five-year figures take investors back to the market peak before the onset of the global financial crisis. The ten-year figures go back to 2002, near the bottom of the post-internet bubble bear market. One theme stands out: the poor performance of many core countries in Europe and the outperformance of a number of emerging markets with strong commodity sectors, such as Mexico, Brazil and South Africa. The UK is one of a handful of developed economies whose stock market has produced positive returns over both periods.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
