INVESTMENT REVIEW - STILL POSITIVE FOR NOW
Politics were again in the spotlight in February as markets sought to digest the worrying results of the Italian elections and the implications of the ongoing political brinkmanship in Washington over the Federal budget.
UK
The Government was dealt a fresh blow in February when the ratings agency, Moody's, downgraded UK government debt. It means that the UK loses its highly prized AAA credit rating and highlights the weak outlook for the economy. With the UK having the second highest deficit to GDP ratio in the G7 countries, and low growth expected to continue, the downgrade looks justified and certainly came as no surprise to the financial markets. Bond yields barely flinched and equity markets remained resilient. Any potential rise in gilt yields is likely to be limited by further quantitative easing (QE) should the Bank of England restart its programme, which we judge to be likely. In the short term, the downgrade could have some positive benefits for the UK economy. On a trade-weighted basis sterling has now fallen by around 6% so far this year, which could give a modest boost to exports and improve the UK's international competiveness. The key question for the Government is whether the loss of the cherished triple-A rating justifies a change in policy, with greater emphasis on pro-growth measures at the expense of continued austerity. The Chancellor George Osborne has tough decisions to make in his next budget on 20 March.
UK equity markets are so far following a similar path to last year, with small and midcap stocks outperforming the larger FTSE 100 index, which remains weighed down by the sluggish performance of the mining and energy sectors. Earnings from two of the FTSE's largest companies, Shell and BG Group, came in below expectations. The technology sector has been the stand out performer, although multiples are now looking stretched. Given its relatively lacklustre economic performance, it is not perhaps surprising that the UK equity market remains attractively priced in comparison to many of its developed country peers. With the 10-year gilt yield falling back below 2%, a prospective dividend yield of 3.8% is also supportive for those seeking income.
US
Mixed signals from the Federal Reserve during the month have put question marks over the central bank's commitment to its QE programme. The chairman, Ben Bernanke, suggested in his recent congressional testimony that the Fed's open market committee is beginning to weigh the costs of its $85bn a month asset purchase programme, one of the first signs that the Fed may be looking to take its foot off the pedal. The negative reaction to the news suggests that the global economy remains too weak to support financial markets without central banks supplying liquidity. Although the inflation outlook in the US appears benign, a number of influential investment houses, including PIMCO and Invesco, are increasing their holdings of index-linked government bonds as a precaution against higher inflation further ahead. It will be no surprise if the Fed reduces the size and pace of its QE programme at some point over the next twelve months, provided that we avoid another flare up in the eurozone and the impact on economic growth of the recently introduced tax hikes is no worse than expected.
Despite the brinkmanship in Congress over tax and public spending plans, US equities had another good month and are closing in on their all-time highs, having outperformed most other markets' year to date. The resurgence of M&A activity is a further sign that confidence is beginning to return to the corporate sector. So far this year around $160bn of deals have been announced in the US, almost twice the amount recorded in the same period of 2012. President Obama's failure to produce a deal with Congress by the deadline of 1 March means that the US faces additional public spending cuts over the course of 2013, and the impact of this 'sequester' will need to be closely watched. While US equity markets are looking expensive on both a historic and relative basis, the superior economic outlook and signs of renewed business and consumer confidence are likely to keep the US market a first port of call for investors looking to move back into equities.
Europe
Fears about the future of the eurozone have resurfaced after an inconclusive result in the Italian general election in February left the nation in political deadlock. The news took equity markets by surprise and the initial reaction was for bond yields in Spain and Italy to edge back up towards uncomfortable levels. A new party known as the 'Five Star Movement', founded by a comedian, Beppe Grillo, was the surprise election success story after it won 25.5% of the votes in the lower house. The pre-election favourite, the pro-euro leader of the centre-left, Pier Luigi Bersani, is trying to form a temporary government, but is hampered by the fact that Five Star says it will not go into coalition with any other party. Mario Monti, whose technocrat government has steadied the ship economically in Italy, reducing the structural budget deficit to 0.5% of GDP in 2012, gained less than 10% of the vote, with voters turning against his plans for further austerity measures. The concern for investors is that Italy appears to be shying away from accepting the austerity plans that have so far helped avoid the need for a bailout by the EU. The political uncertainty could spread to other countries in the eurozone, casting fresh question marks over the future of the euro project in its current form.
The economic climate in Europe meanwhile remains fragile. February's Purchasing Managers' Index (PMI) fell further into contraction territory and continues to highlight the growing divergence between Germany and the peripheral nations in the south. Eurozone GDP fell by 0.6% in the fourth quarter of 2012, a worse than expected result, and economists are not expecting a return to growth this year. In common with a number of other markets, European equities may be losing momentum after a strong run since the summer of last year. On a longer term view, valuations remain below historic averages and attractive relative to the US, but the markets face another choppy ride this year, given the uncertain political and economic landscape.
Asia
Chinese equities have cooled recently after a strong start to 2013, amidst tentative signs that the economy is not firing on all cylinders. February's HSBC Flash Manufacturing PMI fell to 50.4%, its slowest pace in four months. While the late Chinese New Year may have distorted the data somewhat, the figure dampens investor sentiment towards the region's recovery. Yet China remains an economy in transition, and we expect economic growth to moderate somewhat as the new leadership continues to shift focus towards a consumption-led recovery. As a result, sectors such as consumer goods and infrastructure are likely to remain the favoured sectors, as well as healthcare, an area which the Government continues to target for further growth and investment. Both the domestic and dual-listed equity markets look attractively valued on an historic basis and the potential for growth and greater accessibility by investors mean the Chinese market remains attractive.
The volatile nature of Japanese equity markets over the past month suggests that investor sentiment towards Shinzo Abe's new regime may be beginning to falter, after a strong positive initial reaction. Japanese markets welcomed the announcement that Haruhiko Kuroda, head of the Asian Development Bank, will become the new governor of the Bank of Japan. Targeting a higher inflation rate represents a decisive shift away from the previous policy regime, but any reform programme in Japan has to overcome resistance from firmly entrenched vested interests. Investors appear happy to enjoy the ride for the time being, but the large daily moves both up and down in the yen suggest that the pressure on the central bank to maintain aggressive monetary easing will increase further. The surprise 0.4% contraction in fourth- quarter GDP highlights the long-term structural issues facing the new regime, but exports and company earnings should benefit from a weaker yen in the first quarter of this year. With expectations so high, any loss of momentum could bring the advance in Japanese equities lurching to a halt, but the potential gains to investors from a successful revival of the economy could be commensurately large.
Outlook
After a strong January, which took them into overbought conditions, global equity markets have continued to move forward, largely brushing aside the political issues which dominated the headlines. The impact of the elections in Italy and the looming sequestration in the US was mainly felt in an increase in equity market volatility and a gentle retreat in government bond yields. In the US, with the 1 March deadline having passed without agreement, President Obama was forced to begin a programme of $85bn worth of government budget cuts. That threatens to knock 0.5% off GDP and cost up to 750,000 jobs by the end of the year, a headwind that will need to be offset by greater private sector confidence and corporate investment. While the political deadlock in the Italian general election casts new doubts over the future of the eurozone, the extent of the knock-on effects remain to be seen. With most indicators suggesting that equities have become somewhat overbought in the short term, a period of consolidation after the strong start to the year may lie ahead. Analysts have substantially lowered their earnings growth forecasts for 2013 in most regions, reducing the probability that results will disappoint over the course of the year, as they have done in previous years. Dividend yields are a positive for those seeking income. Valuations in many markets including Europe, Asia and Japan, remain below their long run historical averages. While some observers are starting to fret that yields in the corporate and emerging market debt markets have fallen too far, we remain positive for now on equities and corporate credit. Yet the need for vigilance also remains, given the scale of the unresolved issues in the political arena.
MARKET HIGHLIGHTS
Eurozone fears resurface
After a period of relative calm, eurozone worries once again resurfaced this month after an inconclusive result in the Italian general election. Bond yields in Spain and Italy, two of the most highly correlated markets, both spiked following the news that pre-election favourite and pro-euro candidate Pier Luigi Bersani was unable to form a government. The outlook for Italy and indeed, Spain, remains extremely uncertain in the eyes of investors. As a result, five-year spreads over German bunds which continue to be seen as a safe haven asset rose to 3.2% in Italy (green line) and 3.6% in Spain (blue line) following the election, heading back towards uncomfortable levels.
Debt downgrades and bond yields
The UK became the third G7 nation in 18 months to be handed a debt downgrade from ratings agencies. The US and France both lost their triple-A credit rating in 2011 and 2012, respectively. Bad news for bonds one might expect, yet as we can see from the chart the impact of a downgrade has been minimal, in some cases even resulting in a fall in yields. In all three cases, the downgrade appears to have been anticipated by markets. Combine this with question marks over the credibility of ratings agencies, and for now, at least, Government bonds appear immune to downgrade risk.
Volatility in Japan
Japanese equities have continued to rise and the yen has continued to fall following a change in political leadership towards the end of last year. However since the turn of the New Year, the ride has become somewhat volatile. Speculation over who will become the new governor of the Bank of Japan has resulted in large moves in both directions in the yen (green line) and the Nikkei (blue line), the two remaining highly correlated. Pressure will be on the central bank to maintain its aggressive monetary easing stance.
MARKET RETURNS
INVESTMENT Q&A - THE OUTLOOK FOR RETAILERS
David Ravenscroft has been a fund manager at Smith & Williamson, since 1995. He has overall research responsibility for the retail sector.
A lot of retailers seem to be going out of business. Why?
It is often a feature at this time of year. The banks, as secured creditors, tend to pull the plug on struggling retailers after Christmas when they are cashed up, so the suppliers take the worst of the loss. This year has been a busier one than most for the administrators, with substantial chains like HMV, Comet and Republic all closing their doors. The economy isn't helping retailers much, but many of these casualties are outdated formats and it is possible that the banks are calling time on them now they are confident enough to write down their loans.
What types of business are suffering most?
There are two notable themes. One is the decline of the high street which has hit small independents hardest. They have struggled to compete as local authorities discourage traffic (and hence shopping) in town centres, while business rates remain linked to inflation, rather than economic growth or rental costs. The other is the internet and associated technologies which have made some business models obsolete. It is no longer necessary to go into a shop to buy films or music, for example. This explains the demise of HMV, Blockbuster, Jessops and Game Group.
Is this trend better or worse than you would expect at this stage in the cycle?
We have had a spate of insolvencies recently, but over the last five years it is no worse than one would expect, considering the extent of the economic downturn. Many businesses had too much debt in 2008, but those that were profitable at operating level have been able to recapitalise. A similar argument applies to their customers: unlike the experience of previous recessions, interest rates have remained low and mortgages cheap.
Do you expect the trend to continue?
I think we are seeing a gentle improvement, if one takes all retail channels together, and that should continue unless inflation gets out of control. Employment is rising and the pressure on disposable incomes has eased. Higher interest rates would be very damaging however. One should also bear in mind that for each outdated format that has disappeared, another new one has arrived in the online channel. Some, like Asos for example, have been very successful.
Is the internet or the economy the biggest problem?
The economy is sluggish, but that is a better outcome than mass unemployment and a swathe of households in negative equity. As in other sectors, the stronger retailers are looking for growth overseas. In the past the track record of UK retailers abroad has not been great, but the online channel makes it a lot easier to address new markets now. It may be an important feature of the sector in a few years time, especially for clothing retailers.
The internet is both a threat and an opportunity. It has made price comparison easier and allowed low margin retailers such as Amazon to have a much greater reach than they did in the past. This has put a lot of pressure on niche operators, such as Mothercare, for example. On the other hand it has also helped to strip out costs and reduce lead times. Next has been able to double its operating margin by migrating sales online.
What hope is there for the future of the high street?
The high street is becoming a space for leisure rather than retail – hence the profusion of coffee shops. It seems unlikely that this trend will change, as more and more shopping is done online. Part of the problem is local government funding which relies on taxing motorists. We don't have a national policy for high street retail. Business rates are also a problem, being linked to inflation rather than economic growth or rental values. There is scope for policy change, but it does not seem very high on the agenda. Sadly that means that the gap between prosperous and poor areas will continue to widen, in all likelihood.
Who is doing well in this environment?
Online and multi-channel retailers are the clear winners. It is a format that lends itself more easily to apparel than food retailing, but in both cases those who have invested in efficient delivery are reaping their reward. Think Next or Asos. At the discount end of the market Primark has done a fantastic job with footfall and sales densities in its stores, while Amazon has taken what seems like an unassailable lead in the online channel. Perhaps surprisingly, the high end of the mid-market is also thriving. John Lewis Partnership is another stand-out performer.
What factors have proved decisive in their success?
It helps to have modern systems and a good website.
And who is suffering the most?
The structurally moribund – those who offer undifferentiated products in a tired store format. Their sales will continue to migrate online. As consumers become more confident about buying through internet retailers, they will see less and less need to go into shops, when buying electronic goods for example. This poses an ongoing threat to the likes of Argos and Dixons, although they have gained a measure of relief recently with the withdrawal of competitors. On a shorter view, we have another early Easter in front of us which will not help the DIY and garden retailers. They are weather-dependent for a lot of their sales.
How do you see the future of the sector?
We can already see who is making multi-channel work; it remains to be seen who will succeed in taking it beyond the UK. Asos has made a very good start as a pure internet retailer. We could see some very strong brands emerging over the next ten years. The potential market is huge, for those who can access it.
UK SECTOR PERFORMANCE
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