Is it volatile enough for you yet?
At the back end of last year there was one thing that everyone agreed on, even if they couldn’t agree that the US was headed into a recession – 2008 was going to be a lot more volatile. Last week that volatility arrived with a sad inevitability, as markets began their breathless rollercoaster ride through the Fed’s rate cut, SocGen’s discovery of an “extraordinary fraud” and finally, arriving at the gallop, like a desperate envoy, the news of the US’s fiscal stimulus package.
The markets gyrated like a demented dancer, as negative and positive news flow threatened to overwhelm traders. Neil Dwane, CIO, Europe RCM, says that in Europe the markets saw massive futures trading, hedged through the cash markets: “The sharp falls in share prices are therefore trading and hedge fund related rather than traditional investor selling.”
Max King, strategist at Investec Asset Management, attributes the volatility to the fact that investment professionals try to learn from their mistakes. Unfortunately they do this by being ultra-sensitive to the issues that tripped them up last time and reacting as if the problems will recur. “A classic example of this is investors’ paranoia about earnings forecasts,” he says.
King says that investors are making the same mistake as in the 2002-3 bear, where analysts remained optimistic for too long, only cutting forecasts after share prices had fallen and companies were admitting problems. “So while the consensus of analysts’ forecasts shows global earnings growth of 13 pct in 2008, the consensus of everyone else is that these numbers are worthless.”
King points out that this ignores the possibility that both companies and analysts also learned lessons from the bear market. “The impact of the current downturn on corporate earnings should be much less than in 2002-3, but investors don’t believe it.”
In times like these it is tempting to cleave to the arguments of the behavioural financial analysts who say the best thing to do is simply to ignore the madness. Contradictory news flow getting you down? Don’t know which way to turn? Then just retreat to a cloister for two months until everything settles down again.
“The classic advice to investors in periods of considerable volatility is to not make big ‘knee jerk’ changes to portfolios,” says Andrew Milligan, head of global strategy at Standard Life Investments. “If there is spare cash, look out for any ultra-cheap assets, whether individual stocks or markets, which have experienced panic selling.”
He adds that there is usually a short-term rally after such a sell-off, but a genuine, sustained uptrend normally takes months to develop. “Investors need to see much more evidence not only that all the news has been fully priced into markets but also that negative trends on earnings and business activity are turning positive again. The worst might be over but, just as importantly, investors should prepare for more pain to be felt in 2008.”
It’s little comfort to know that such volatility is typical of this stage of the cycle. But with the bear out of the cage, contrarians are looking for bargains. RCM’s Dwane points out that there is a world outside the US, and investor capitulation, whilst painful, will soon provide a great entry point into the markets. Tony Stenning, managing director of UK retail at BlackRock is also sanguine: “Now is the time to look behind the charred exterior and spot the value shining through….Even if there are further undulations ahead, investors are likely to do well on 3-5 year view.”
Fed still taking fire
Right now it seems like Federal Reserve chairman Ben Bernanke is damned whatever he does. Having resisted Wall Street’s cries for help with only three rate cuts since September, the Fed was arguably bounced into an inter-meeting rate cut this week by Monday’s widespread sell off.
But with the US markets closed on Monday, the selling continued on Tuesday, and economists have been largely unimpressed by the Fed’s move. The subsequent announcement of the discovery of rogue trading at SocGen simply added to the excitement.
New Star’s economist Simon Ward has been particularly critical of the Fed’s decision to cut rates by 75 basis points, arguing that it is far from clear that the economy – as opposed to Wall Street – requires such a dramatic stimulus.
“Available evidence suggests GDP expanded in the fourth quarter,” he commented. “Real interest rates were not high before [Tuesday]’s action and the Fed did not feel the need to cut by more than 50 basis points in a single move in the last two recessions.”
He also pointed out that cutting rates nine days before a scheduled policy meeting had created the impression that the Fed had been panicked into action by global equity market falls. “Investors will now expect further reductions if equities continue to weaken, regardless of the wider economic context,” he said.
But Bob Baur, global head of trading at Principal Global Investors, said that the Fed was worried about small and medium-sized US companies being hurt by credit tightening by the banks, which would transform a financial markets crisis into a real economy crisis.
“There is no question that the Fed needed to lower interest rates,” he said. “Although the problems are in the financial markets, there has been a crisis of intermediation and banks’ balance sheets are full of risky assets. The Fed wants to make sure that the reduced availability of credit doesn’t hurt ordinary US businesses, and to generate a steeper yield curve.”
Baur said that he was still in the optimistic camp over the US economy, although he accepted that the first and second quarters would be weak. “But the jobless claims are still pretty positive, there is more transparency now in the market with regard to write downs and the sovereign wealth funds are helping to rebuild.”
You can read more initial reactions to the Fed’s rate cut here:http://www.thomsonimnews.com/story.asp?sectioncode=3&storycode=34560
No consensus on Japan
The Japanese equity market has whipsawed like an angry snake this past week as fears that a slow down in export markets will hit large cap manufacturers have combined with the need for stricken institutional investors to increase their liquidity and realise cash. With foreign investors quitting in droves, January’s freefall was only arrested at the end of this week, when Japanese equities recorded their largest one day gain since March 2002.
Paul Sheard, chief global economist at Lehman Brothers, says that Japan has disappointed foreign investors as it has failed to reflate and domestic demand has remained weak: “It is now looking increasingly vulnerable and the question is whether it will slip back into recession even before it has gotten out of its decade-long deflation.”
Japan has long proved a vexatious market, frustrating those who see strong company fundamentals but ultimately failing to fulfil its potential. Between 2003 and 2005, Japan’s economy was driven by export-oriented companies, but then it began a big rally on the expectation that banks, real estate stocks and retailers would benefit from domestic demand growth. “This created a mini-bubble in these stocks which has now brutally come to an end,” says Albert Abehsera, portfolio manager and CIO at IFDC.
Ed Merner, president of the Atlantis Investment Research Corporation, and a long-time resident in Japan, attributes part of the decline to a loss of confidence amongst retail investors caused by the media. Japanese retail investors are the second biggest players in the market, and they have been selling for some time.
“The news of a global economic slowdown has worried people and businesses are losing confidence,” he says. “As the economy has been in a slump or a low growth period for some time now, people are very cautious and bad news frightens them.” Small and mid-cap stocks have no support, but even some of the big stocks are falling very fast, according to Merner: “It’s not a pretty picture and people are very scared.”
This is despite the fact that the fundamentals are not bad, exports remain pretty strong and private capital investments have been pretty good. However, overall sentiment has been affected by a construction housing scandal and poor wage growth. “Many Japanese corporates are using temporary workers more and more to reduce fringe benefits,” says Merner. So even though the Japanese labour market is tight, especially for skilled labour, corporate profit growth hasn’t translated into higher incomes, and consumer demand has remained sluggish.
Market participants who subscribe to the domestic demand-led recovery theory, such as Hideo Shiozumi, manager of Legg Mason’s Japan Equity Fund, believe that there may be increases in monthly salaries this year. But other seasoned Japanese equity managers are more sceptical. Abehsera questions how wages can go up in the current environment if they didn’t during the relatively prosperous period of 2003-2007.
“I am flabbergasted to hear these comments because wages didn’t go up when companies were making money from exports,” he says. “And small companies stopped making money in 2005. They were unable to pass on raw material and oil price increases to their customers and their margins were squeezed. But two-thirds of the Japanese labour force is employed by SMEs.”
He adds that large companies have made money from cost reductions and export growth, but instead of increasing wages they have preferred to reduce debt and pay more dividend, as well as invest in machinery. “With the outlook turning gloomy, they are unlikely to increase wages now. It would be unwise for them to do so at a time when their earnings may be under pressure from lower sales overseas.”
Two stories posted on Thomson IM News this week explore these different views in more detail. But even the less optimistic managers see the current whipsaw market as a chance to hunt for good companies at low valuations. Pascal Masse, head of Japan equities at Aberdeen Asset Managers, says that investors need to shut out the noise and not worry about Japanese politics or the yen versus the dollar. “The main downside risk is a US downturn, and if it impacts Asia it will hurt Japan’s export markets. In the domestic market I see no negative change, in fact, it may actually improve. Japan looks set for much of the same – slow, gradual growth.” The fact that the market bounced back on news of the US stimulus package and strong Asian data, suggests the rollercoaster ride is not over yet.
Access the view from the Japanese bulls here:
http://www.thomsonimnews.com/story.asp?sectioncode=7&storycode=34601
For the more bearish take on the market, click here:
http://www.thomsonimnews.com/story.asp?sectioncode=&storycode=34768
Danger of getting too bearish on equities warns RLAM
Royal London Asset Management’s Jane Coffey says financials will be toughest sector to call – but picks out HSBC and Lloyds TSB as best of a bad bunch.
Investors face a real danger of getting too bearish on equities, according to Jane Coffey, head of equities at Royal London Asset Management, but timing the upturn, and especially the right time to go back into financials, will be tricky amid a series of false dawns.
M&S vs FTSE – from Thomson Datastream
On the whole, Coffey is cautiously optimistic on equities, but she stressed this is related to valuations, which are not at too high a multiple. ‘Bond to equity yields are at 30 year lows in the UK, which suggests that equities are cheaper than they have ever been,’ Coffey said. ‘Equities versus other asset classes haven’t re-rated this cycle, but we’re at the peak of the earnings cycle now, so the question is how far will they fall over the next few years?’
She said that as interest rate cuts are expected, this should trigger a re-rating of equities based on trough earnings: ‘We’re seeing quite a lot of value in the market now.’ In this environment, Coffey said RLAM was positive on cash in the short term, as it wants to be ready to go back into the market when the earnings downgrades are discounted and the interest rate recovery is coming through. ‘But it will be very volatile with a lot of false dawns,’ she warned.
She thinks that the upturn might appear first in financials, where RLAM is currently underweight, but added: ‘We don’t want to get too weighed down by negativity and miss out on the opportunity to make money.’
In this troubled sector, she said she will look for banks making big write downs and becoming more realistic about impairment charges, which she believes are still too low. Last week Lehman Brothers recommended an overweight to financials, arguing that the sector appeared oversold, and that the dividends being paid are much higher than the current market price would indicate.
‘Banks are at unprecedented lows, but that doesn’t mean they are necessarily a good buy – it might be that they can’t pay the dividend yields they are projecting,’ countered Coffey. ‘Banks don’t like cutting their dividends, but it is starting to happen in the US, with Citigroup for example, and I expect the Royal Bank of Scotland to cut because it is looking overstretched.’
In this sector she said RLAM holds HSBC and Lloyd’s TSB, which seem the least bad of the bunch. ‘The balance sheet at HSBC is in reasonable shape – there is nothing bad enough there to suggest a dividend yield cut or a rights issue,’ she said. ‘They have some exposure to US sub-prime and will probably have to take some write downs but it is a drop in the ocean for them and they have good growth prospects in Asia.’
She added that Lloyd’s TSB (see chart) has only just increased its dividend yield after a long period with a flat dividend. This was related to its poorly timed acquisition of Scottish Widows, which made the bank capital constrained and hence conservative at a time when the other mortgage banks were extending large amounts of cheap credit: ‘This means they are not over-stretched and this should be one of the more guaranteed yields in the market.’
Lloyds TSB vs FTSE – from Thomson Datastream
However, Coffey added that RLAM remained very cautious on the UK economy, with a number of concerns about the over-indebtedness of the consumer and high house prices. She pointed out that building volumes have been a lot lower in the UK compared with the US, so there is no massive over-supply, but affordability ratios are overstretched: ‘So house prices will decline and the UK economy will face a tough time in 2008.’
Instead, Coffey says RLAM is looking to the BRICs, which it believes are now so big that they can rely on their own internal growth generators. In particular, RLAM is overweight on oil and the mining sector, as the main drivers for resources continue to be from the emerging markets.
For more please visit: www.thomsonimnews.com
Pass the candles please, it’s dark in here
January 30, 2008 at 2:04 pm (Macroeconomic commentary) (Inflation, interest rates, stagflation, UK)
It was Dr Marc Faber who first raised fears of a return to a stagflationary era, not unlike the dark days of the 1970s. Faber is often accused of being too negative, but last week Bank of England governor Mervyn King also seemed to be hinting this was a real danger for the UK.
So should we prepare for a return to mass unemployment, high inflation and hideous wallpaper? Are frequent power cuts just a bitter pay dispute away? It seems unlikely, not least because of the rampant privatisation of the 1980s and the erosion of trade union membership, but there is a recognition that the UK is facing a number of knotty problems, giving the Bank of England a choice between two evils.
Economists have criticised the government for running up a huge public sector deficit, but having been elected on a platform of investment in health and education, one can hardly be surprised. The problem is how to tackle inflation and slowing growth when the fiscal levers are likely to be out of bounds.
This week Jim Wood-Smith, head of research at Williams de Broe raised the spectre of public sector unrest as the government struggled to hold the line against wage increases. With the individual’s personal inflation experience running ahead of the CPI, the swollen public sector is likely to become increasingly pugnacious.
Meanwhile, Tim Drayson, senior economist at ABN Amro, says that the Bank of England needs to see inflation expectations come down before it can reduce interest rates. This suggests that a great deal of pain lies ahead for the UK consumer, who has been spending on tick for the last 10 years.
“Inflation needs to be squeezed out by weaker growth,” he says. “But the UK is running a large current account deficit and the pound is still overvalued.” If the pound falls sharply, as Mervyn King has hinted should be allowed to happen – this would be more inflationary than in the US, as it would make the UK’s imports more expensive. Cue further grumbling from workers and a fresh round of pay disputes. “We need a significant slow down in growth to sort this out,” Drayson says.
He thought the next few years would be more like the 1970s than the 1990s, but stopped short of mass industrial unrest and rubbish piling up in the streets: “It won’t be as bad as that.” However, there are worrying clouds on the horizon – the foreign capital flows that helped offset the UK’s mighty trade deficit may dry up if the economy starts to look wobbly and the pound is allowed to devalue.
And with the financial services sector heading into what is likely to be a tumultuous reporting season, one cannot expect the City to balance the scales. Instead, the UK’s anaemic manufacturing base may have to start taking up the slack.
In the US, the picture is much less gloomy, despite weeks of recession-mongering from determined pessimists. A stimulating fiscal package worth 150 bln usd is expected to arrive in a timely manner, and it is, after all, an election year. Meanwhile the Fed is expected to continue cutting away like crazy in an attempt to stave off disaster.
As a result, Drayson says that inflation will remain an issue due to inflationary pressure from overseas and the fact that the labour market is relatively tight. “Wage growth hasn’t declined but productivity has slowed and that is putting pressures on margins.” He thought that companies will absorb this until 2009 but then they will start to increase costs. “So the Fed will need to reverse direction pretty quickly into the upswing and raise rates.”
You can read more about the possible return to 1970s-style public sector wage disputes and the problems of persistent inflation at:
http://www.thomsonimnews.com/story.asp?sectioncode=7&storycode=34940
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