Investment Management Outlook – March 2006

For much of 2005, we drew attention to the fact that, while corporate war chests have been swollen by a combination of soaring profits, companies were reluctant to reinvest in new plant, preferring instead to make share buybacks and acquisitions, and we believed that this would act as a major support to global markets. Since the start of 2006, the pace of takeover activity has undergone a step change, with the prices for target companies reaching impressive levels as bidders fought for control of scarce assets, while being able to avail themselves of cheap credit. We therefore believe that the feeding frenzy will continue, even though history has proved that acquisitions are as likely to destroy as to create value. Investors should enjoy the ride, but be prepared to sell the shares of bidders that put corporate egos ahead of value for money. Leading companies in the energy and mining sectors now feel unable to employ their funds profitably in new investments and are returning huge sums to shareholders. UBS has calculated that the world’s five leading oil companies alone could return up to $250bn to shareholders in the form of share buybacks over the next three years, depending on the oil price, and this cash will undoubtedly be recycled into other equities. We remain bullish for markets.

The US economy is losing altitude – the question is how rapidly. Q4 GDP grew by a mere 1.1% (annualised) against expectations of +2.8%, thanks to a steep downturn in both capital investment and consumer demand for durables, especially cars. We suspect that these figures are underestimates, and will be revised up in future months. Indeed, a mild January triggered a strong rebound in both retail sales and housing starts. Personal income growth is slowing, but according to the Commerce Department, this has not held back expenditure, which has so outstripped incomes that the savings ratio has fallen to -0.7%, the eighth consecutive month in negative territory. The scope for continuing to spend in excess of income by using one’s home as a giant ATM has been significantly impaired by a combination of rising mortgage rates, a fall in affordability to a 10-year low and signs that the rise in prices is faltering. The Fed’s new chairman, Ben Bernanke, believes that the housing market will have a soft landing, but in our view, the US remains the weakest link in the global economy, unless a falling oil price throws a lifeline to the consumer.

The UK consumer has for years been closer in his spending habits to his US counterparts than to those on the Continent, but the recent messages have been mixed. On the one hand, consumer credit in December showed the weakest rise in 5 years, on the other, consumer sentiment is reviving, house prices in December were unseasonably strong and the number of mortgage approvals was the highest since May 2004. Indeed, some commentators predict that house prices may be rising at a 10% rate by mid-year. Thanks to a marked switch in consumer preference from actual shopping to Internet shopping, demand for retail space has plummeted over recent months, and it is clear that, despite the support of low interest rates, investors in property will have to be more discriminating this year. Warehousing for Internet retailers looks more promising than shops on the High Street.

Despite our worries that investors are becoming overconfident, the UK equity market is showing renewed strength, powered by a wave of takeovers. We believe that this is the happy result of three factors that have become more pronounced over the past few months. Firstly, strong pension fund demand for long-term income streams, forced upon them by their actuaries, has driven down longterm bond yields, making equities seem relatively attractive. The latest budget data indicates that the government will need to issue £3bn less debt than the £40bn previously forecast, further aggravating the supply/demand balance. Secondly, strong cash-rich balance sheets and low borrowing costs, driven by the same low bond yields, encourage takeovers. Finally, chauvinism has re-emerged in Europe, where governments are closing their doors to foreign predators such as Mittal, which is bidding for Luxemburg’s ‘national treasure’ Arcelor – ignoring the fact that Arcelor itself has been on the acquisition trail overseas. The French government intends to submit an amendment to the takeover law currently going through parliament authorising companies to launch ‘poison pills’ if subject to, or anticipating, a hostile bid. The UK, by contrast, puts few barriers in the way, which is as good as putting a ‘For Sale’ sign on UK plc. The net result is that the buying power of the corporate raiders has been focused in UK equities. With a bit of luck, we will continue to see further bids at the wrong price.

How refreshing to find a government that is not prepared to make exaggerated growth projections. In shining contrast to Gordon Brown, Angela Merkel is resisting the siren calls of politicians and trades unions alike to rescind the 3 percentage point rise in VAT scheduled for next year. They claim that the economy is showing a robust recovery and such a swingeing tax increase will be unnecessary to keep the budget deficit below 3% of GDP. Not so, says the Chancellor. GDP growth will be only 1.4% this year – a figure well below market expectations of 1.9%. We believe the market is right, even though retail sales for November and December have been disappointing. The latest ifo and ZEW surveys of business and consumer confidence have been very optimistic. Furthermore, while the government had pencilled in a €4bn loss for the Federal Labour Agency, which distributes unemployment benefits, thanks to tougher unemployment criteria, its 2005 deficit was only €347m. The unions are on the warpath for higher wages, but their power is being blunted by ongoing corporate restructuring. Volkswagen, for example, is seeking to cut 20,000 jobs in Germany. The nation’s largest trades union, Verdi, has embarked on the largest public sector strike in 14 years. At the time of writing, the Chancellor has refused to intervene; let us hope she keeps her nerve.

Elsewhere in the Eurozone, there are signs that the Spanish economy is slowing down – which could explain the renewed interest of Spanish banks and construction groups in overseas acquisitions.

Over the past two years, investors have enjoyed a very profitable ride in the Japanese market, but while the party atmosphere has been buoyed by the arrival of latecoming US generalist funds, early investors have begun to ask whether most of the fun is over and it is time to leave. The latest GDP data, for the three months to December were impressively strong. The economy grew at an annualised 5.5% rate, while personal consumption (+3.2%), capital investment (+7.2%) and housing investment (+7.6%) outpaced net exports (+2.4%), showing that the export boom has finally rippled into the domestic economy. Investors were unimpressed, however, and shares fell. Admittedly, valuations are looking somewhat stretched in PER terms, but we do not believe that this is the only yardstick driving the market. The recovery in asset values has had a far-reaching impact on the banking sector, and hence on the wider economy. MUFG, the world’s biggest bank by assets, reported in February that it has raised its net profit forecast for the year to 31st March 2006 from Y830bn to Y1170bn. Borrowing, especially by home buyers, is precisely what the economy needs to sustain the transition from exports to consumption. Profit taking after the GDP data brought the Topix back to a support level, and the market has since rebounded strongly from a very oversold position. We remain happy to hold.

Elsewhere, the Chinese economy continues to expand. Retail sales are growing by 11% compound in real terms and auto sales in January grew by 70%. Between them, the two Asian giants are likely to ensure that the global economy continues to expand at an above-trend rate this year.

Smith & Williamson Investment Management, a trading name of NCL Investments Limited (Member of the London Stock Exchange) and Smith & Williamson Investment Management Limited. Both companies are authorised and regulated by the Financial Services Authority.

Disclaimer: This document contains information from sources believed to be reliable but no guarantee, warranty or representation, express or implied, is given as to its accuracy or completeness. This is neither an offer nor a solicitation to buy or sell any investment referred to in this document. Smith & Williamson Investment Management documents may contain future statements which are based on our current opinions, expectations and projections. Smith & Williamson Investment Management does not undertake any obligation to update or revise any future statements. Actual results could differ materially from those anticipated. Appropriate advice should be taken before entering into any transactions. No responsibility can be accepted for any loss arising from action taken or refrained from based on this publication. Smith & Williamson Investment Management is a trading name of NCL Investments Limited and Smith & Williamson Investment Management Limited. Authorised and regulated by the Financial Services Authority.

© Smith & Williamson Investment Management Limited 2005