The Reckoning

‘In 2003, the last time the market bottomed out, there was bad news all the way until the end of the year, but the rally started earlier,’ she said. ‘The thing that concerns me most is getting too bearish. When does the re-rating begin? When does the bad news stop weighing on markets?’She noted that at present, any stock that disappoints gets crucified, as Marks & Spencer discovered at the start of this month, although it has since recovered slightly against the FTSE 100 (see chart).

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.’

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.

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