Equity investors can still look forward to a couple more years of positive returns, says Peter O'Connor of Investment Manager Selection in his latest monthly commentary.

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In a world dominated by spin, opportunism, greed (both corporate and individual) and short-term performance it is necessary to step back from the “noise” and check the medium-term outlook.  Money, credit, economic growth and earnings, geo-politics and climate are the framework from which we fashion our initial asset allocation decisions.  Thereafter we choose investment style, market capitalisation and technical analysis to complete the selection of managers and construction of appropriate portfolios.  Where are we now?

 

Central Bank Tightening Continues

 

To the dismay of many short-term strategists the Federal Reserve gives every indication that it will maintain current rates throughout 2007.  Given the confusing signals being sent by short-term data/indicators this is appropriate.  Compared with consensus expectations at the beginning of 2007 inflation and interest rates have been higher than expected in much of the world.  The Bank of England is faced with a similar problem and the ECB has just raised its rate to 4%, the fifth increase in 12 months.  Yet monetary policy is not restrictive: in the UK real interest rates are 2%, US rates are broadly neutral and ECB rates still accommodative.  With oil and soft commodity prices rising again global supply and demand can re-inforce domestic pressures.  Central banks may be forced to tighten monetary policy again.

 

Bond Markets Take Notice

 

The recent sharp rise in global bond yields is the equivalent of a further tightening in monetary policy.  If bond yields are rising to reflect increasing market expectations for official rates we could expect further increases.  But, more likely, the pressure is off central banks as long term yields now reflect rising official rates: the “conundrum” may be removed as current account surpluses from Asia and the petro-dollar countries are deployed in encouraging domestic spending and recycled in the capital markets of the developed countries.

 

Bond yields have increased rapidly in a short period of time.  The important bench mark yield on 10 year US Treasuries moved from 4.7% to 5.3% in a couple of weeks.  This, in turn, triggered a world wide increase in long-term rates in June.  The markets are understandably anxious that the structural conditions that have kept global bond yields so low may unwind. 

 

Writing in the Times (18th June) Anatole Kaletsky analysed the structural factors: a) regulatory and accounting pressures on pension funds in Anglo-Saxon countries to move substantial portions of their assets from equities to bonds; b) the search for higher returns by Japanese investors; c) the activities of Asian central banks to keep their currencies relatively cheap and d) the huge increase in wealth of oil producing countries whose official institutions focus on bonds as a primary source of investment.  These influences on global markets enabled the low real yields. 

 

Mr Kaletsky argues that the first two factors are still in place.  The latter two may be changing as these countries seek to diversify some of their investments and, more importantly, try to contain the side effects of currency manipulation; rising domestic inflation and financial bubbles.  In addition, investors have become more convinced that the US economy maybe gradually moving out of the present slowdown which makes it unlikely that the Federal Reserve will reduce short-term interest rates.

 

The result of all the above is the yield curves are no longer inverted: they are now sloping upward.  A higher “risk free” rate will eventually increase the financing costs for all borrowers: US or UK homeowners arranging their mortgages, hedge funds leveraging their assets and private equity groups engaged in Merger and Acquisition activities.  It is too early to judge whether this means a loss of appetite for riskier assets.  Despite the rapid rebound in equity markets this re-pricing of risk may be a turning point and promote a healthy correction of current specific excesses in global financial markets and the over-weaning complacency of investors after the excellent returns of the past four years. 

 

Monetary policy and financial valuations may be returning to normal.  The levels of inflation, credit spreads and the Yen carry trade are the key components to monitor.  The problems now besetting two Bear Stearn highly leveraged funds in the US sub-prime mortgage market illustrates the problem.  Mortgage backed assets, and a key derivate index (ABX), have recorded record lows

 

USA: Global Economic Locomotives

 

As noted earlier the latest economic date indicates that the USA may be emerging from the economic slow-down focused mainly in the housing, building and construction sectors.  Higher interest rates, energy and food costs have been offset by continuing strength in consumption expenditure, high productivity and improving competitive exports as the value of the US$ declines.  Problems remain: US household savings are fragile and the consumer is significantly indebted.  Against this US corporations are generally in excellent financial health with strong balance sheets, growing earnings and high levels of free cash flows.  Wages are stable or rising while the labour market remains tight. 

 

The latest IMS visit to the USA reported that, assuming earnings of $100 for the S&P 500 in 2008, the relative valuation at 15x 2008 earnings is reasonable.  Large cap growth-orientated stocks offer the best value to managers interviewed.  Mid-cap stocks offer selective value but small-cap companies are expensive.  Strong liquidity, merger and acquisition activity, and private equity investments in free cash flow yields which remain above the cost of borrowing, offer decent support for US equities. 

 

But Marc Faber reminds us that “the danger remains that in a credit, and hence asset price-driven economy, money supply and credit must continue to grow at an accelerating rate in order to sustain the expansion” (F.T. June 20th).  When this ceases as the market tightens lending standards for mortgages one can expect contracting liquidity and consumption.  Meanwhile, the US dollars continues its secular decline but, short-term, less accommodative monetary policies will support it.

 

UK : Mr Brown Steps Up

 

The long self-congratulatory exit of Mr Blair finally permits Mr Brown to take over as Prime Minister.  As expected he is careful to keep his cards close to his chest.  The change-over will not be dramatic.  Expect less glitz, more sobriety and micro-management.  This, allied with high levels of bureaucratic interference, does not auger well for entrepreneurial development in the UK.  As Germany, and now maybe France, endeavour to reduce taxes and surveillance the Government and unions here are moving in the opposite direction.

 

Europe: Eurozone Confidence at a 6 year high

 

The European Commission reported that its “economic sentiment index”/for the 13 country eurozone had risen sharply.  Consumption, employment and capital investment, particularly in Germany and France, are improving notably.  The victory of Mr Sarkozy in the recent presidential election, and the centre-right UMP in the parliamentary elections, secures a significant mandate for reform.  These include cutting social charges for employment, shifting the tax burden to consumption and removing other structural obstacles which have stifled growth in France for so long.  Business, employees, education, capital investment should all benefit while bureaucrats and unions will have their wings clipped.

 

 

Russia : post the St Petersburg Economic Forum

 

The consensus view in Moscow at present is that Mr Ivanov will be chosen by Mr Putin to succeed him as President next year.  The former opened the forum with an important speech detailing the economic policy of the President and Government.  In summary, the aim is for Russia to figure in the top five world economies by GDP in 2020.  Foreign investors and the state would play key roles.  Nuclear energy, aviation, ship building and defence-related businesses are the sectors specifically identified.  Publicly listed corporations, rather than nationalised ones, with internationally competitive capabilities are the benchmark.  The targets are ambitious! 

 

Elsewhere Mr Putin called for a new world economic order favouring developing economies and more regional trading groups.  CEOs were asked to back Russia’s bid for the WTO.  Mr Gaider (former PM) reiterated the need for sustained fiscal rectitude and saving to ameliorate social conditions and fund pensions for an ageing population.  Russia continues to offer substantial investment rewards while remaining a place of significant risk as a result of political interference, lack of corporate transparency and corruption.

 

China

 

Inflation is now more clearly evident in China.  Prices rose 3.4% in the year to May (yoy); the most rapid increase in 2 years.  Food prices (especially grain) are a particularly important component and further increases can be expected.  This in turn puts pressure on wages, now increasing 15% yoy.  These have been absorbed by improved productivity or lower margins.  Exporters are finally moving to raise their prices.

 

Frank Gong (JP Morgan) argues in his June 7th Report that China is managing excesses while sustaining growth.  The authorities are still comfortable with the state of the real economy, taking particularly satisfaction in the improving quality of growth.  All sectors of the economy – households, corporations and public - are participating.  GDP growth of 10.8% is forecast for 2007.  A combination of modest interest rate increases with a widening of the CNY/USD trading band and expanded offshore investment (QDII) has relieved some of the pressure resulting from excess liquidity. 

 

Concerns about an asset bubble remain.  For a large economy, annual GDP of about US$4.0% trillion and growing at 10.0% average over the past 5 years, hosting the Olympics is not a “big economic deal”.  It is barely visible in the provinces outside Beijing.  The likelihood of a post-Olympics slump is thus small.  China continues to be a powerful platform for growth, especially in the Asia-Pacific region and for commodity producing countries worldwide.

 

Japan

 

This has proved a disappointing country in which to invest, in the past 18 months, especially for those based in euro or sterling.  While the economy outperformed the USA and the eurozone in Q1, 2007 (+3.3% yoy) this economic recovery has been focused especially in the export and capital investment sectors.  Domestic consumption has remained relatively weak.  Widening income disparity and improvement in property prices only in the Tokyo/Osaka region has limited the broad recovery which investors had hoped for.  Expectations in 2006, after a wonderful 2005, were too high. 

 

2007 prospects are quite optimistic though matters are not helped by the conflicting statistical evidence offered from the Ministry of Finance and the Prime Minister’ office.  Exports are very competitively priced as the Yen weakens further.  There is strong global demand for capital goods and equipment and more sophisticated technology/logistics products.  Japan benefits from strong infrastructure expenditure in Asia and emerging economies. Overall spending on services has increased by 10% (yoy).  A recent visit from Warwick Johnson (Optimal Fund Management) made the above points successfully. 

 

Continued weaker consumption is reflected more in the domestic sectors.  Here competition is strong and margins squeezed.  Large cap stocks benefit from exports/capital investment/property/global infrastructure sectors.  Smaller caps are still suffering in the retail/leisure/building sectors.  An IMS visit to Japan in June concluded that the worst of the impact of deflation is over but was ambivalent about market valuations.  The “carry trade” sees capital outflows of US$15billion per month.  Overseas investors account for 60% of daily trading volume.  A small cap recovery will be delayed to 2008.

 

Professor Gerald Curtis (Columbia University) believes that Japan is entering the third great change post the Meiji Restoration and the post war reconstruction: an end to “convey capitalism”/cross-holdings and inefficient, huge public works programmes to buy votes.  Accountability is slowly forthcoming.

 

Japanese companies are not geared like their counterparts in the Anglo-Saxon world.  The Yen is cheap and likely to remain so as the rise in interest rates will be very gradual.  Private equity, a part from the financial sector, is largely absent from Japan.  Japan will lose less in any significant correction of global equity markets.

 

Sovereign Wealth Funds

 

US Government estimates of the assets of such funds range from US$1.5 trillion to US$2.5 trillion invested in assets worldwide.  There is a further US$5.0 trillion currently held in central bank reserves to augment these funds.  The motivation and transparency of these funds can clearly influence the international financial system.  These huge public sector funds may have different objectives to a private sector, market-based global financial system. 

 

Will Sovereign Wealth funds inhibit the reform of currency regimes and capital account liberalisation?  The Economist (May 26th) estimates that the world’s entire supply of bonds is US$55 trillion with another US$55 trillion for equities.  These funds are already key participants in these markets.  They are also engaged in diversifying their overseas investments in currencies from the US$ to Euros, £ sterling and maybe Yen.  Norway is the benchmark for transparency as regards investment portfolios and returns.  Will others follow suit?  Do they seek economic returns, strategic resources or political objectives?  China  ($1.3 trillion of reserves), and the Gulf States ($1.5 trillion) are the key influences at present.

 

Conclusion

 

One of our favourite economists, John Greenwood (AMVESCAP Chief Economist), argues the following: a) after 3 quarters of sub-par growth the US economy is likely to resume more vigorous growth; b) the global business cycle expansion is intact despite, higher levels of inflation in the US and UK, strong commodity prices, the US mid-course correction and periodic worries about the “carry trade”.

 

Corporate earnings growth is positive: the earnings yield on equities remains attractive in most countries.  Global growth is likely to remain strong in 2007: the IMF forecasts 4.9% v 5.4% in 2006.  The pronounced resilience in the euro-zone, China, Asia-ex Japan and India implies that the world is moving from a uni-polar, US-led global economy to a more multi-polar one.

 

Equity investors should look forward to another couple of years of positive returns.  As the business-cycle expansion matures the risk of inflation increases leading to tighter monetary policies and a prospect of recession.  He compares the present situation to the second half of the 1990s, after rates were normalised in 1994/5.  The outlook remains favourable.

 

Peter O'Connor