UK: Investment Management Outlook, November 2006

Last Updated: 13 December 2006
Article by Richard Cragg

World Markets Looking for trouble

Global equities continued to advance over the month, despite some economic crosscurrents that made the Oil and Mining sectors particularly volatile. The fears of a US slowdown driven by the housing market were somewhat alleviated by the ongoing weakness in the oil price as inventories rose and the risk of disruption from hurricanes or Middle East tensions faded into the background. At a stroke, this boosted household spending power, drove down inflationary expectations and led to a sharp fall in bond yields and mortgage rates. Suddenly, it appeared that the US housing market and the economy were no longer heading for a hard landing, corporate earnings would not be under pressure and equities had become more attractive, when priced against lower bond yields. On the other hand, Oil and Mining shares initially tumbled on the view that their value as inflation hedges had diminished, and that the hitherto favourable supply/demand balance was deteriorating. As a result, the FTSE100 Index, which is heavily dependent on these two sectors, began to underperform, before investors began to recognise that a soft landing for the USA was supportive of stronger commodity prices. The decision of OPEC to cut production by 1.2m bbl/day to underpin the oil price at around $60/bbl provided further backing to oil, gold and base metals.

Global fund managers themselves seem divided about prospects. Thus the latest Merrill Lynch regional survey shows a general consensus that the global economy and corporate earnings are slowing; but despite their regarding the European, and especially the US equity markets as undervalued, they lack the courage of their convictions to run down their overweight cash positions. They should.

After the mid-year market correction, we became consistently more optimistic about the prospects for global equities. We see further upside potential, based on a still healthy world economy, modest valuations and ongoing growth in corporate earnings. Nevertheless, it is prudent to give an early warning of possible obstacles ahead. Over the past two months, the prices of soft commodities – corn, wheat and soya – have all risen strongly, reflecting low stock levels, and in part, the expectation of strong demand for biofuels (alcohol and biodiesel) derived from these crops. Unfortunately, these are direct inputs, not only for bread and beer, but for a variety of other foods, and are major inputs in the cost of raising livestock. So far, the price increases this year will add only another 0.5% to inflation over the next three years, but we continue to monitor the situation, since rising inflation and rising bond yields are detrimental to equity valuations.


The cloud of unknowing

The market has become very divided about the future course of the US economy, and is expressing a wide range of opinions, each of which is supported by influential research organisations:-

  • hard landing
  • delayed hard landing
  • extended correction
  • soft landing
  • growth resurgence

We believe, however, the risk of recession has been significantly reduced by the fall in both the gasoline price and mortgage rates, and if history is any guide, the current slowdown looks increasingly like a mid-cycle correction rather than anything worse. Indeed the Conference Board Leading Indicator rose in September for the first time in three months. The Dow has risen above the 12,000 level, despite the fact that support for the business-friendly Republicans has slumped ahead of the mid-term elections. Share price Volatility is back to a 13-year low, suggesting that investors believe that economic cycles have become less extreme, as the actions of governments that might affect economies adversely are increasingly constrained by the independent Central Banks and by the foreign exchange dealers, who punish political irresponsibility. The corporate results season so far has passed with few unpleasant surprises, and we believe the market has further upside.


Bad news – falling corporate tax rates?

Despite a strong QIII GDP number, which saw the economy growing by 2.8%, this has yet to translate into a healthier budget position; the latest monthly deficit, £12.3bn, was the highest September figure on record. VAT receipts are still suffering from carousel fraud, but corporation tax receipts are booming, and the companies are beginning to protest. It is said that there are two things one cannot avoid – death and taxes – but companies domiciled in the UK are trying to stave off, or at least mitigate, the latter by moving to lower-tax domiciles. This will put pressure on the Chancellor to find ways of reducing the tax burden on companies, but there is no suggestion from the Treasury that government expenditure will decline pari passu. Accordingly, we cannot expect him to be generous to his captive market – individual taxpayers – few of whom are in a position to change domicile. (Paradoxically, Schefenacker, a German autoparts company, may move its registered headquarters to the UK in order to accelerate an agreement with its creditors, because of the rigidity of the German restructuring rules. Since such companies are likely to be lossmaking, the Chancellor is unlikely to benefit from this traffic.) Meanwhile the Bank of England remains hawkish, with the two new members uncharacteristically voting for a rate increase in September. The Old Lady fears that the economy is growing too fast for comfort, and that interest rates will have to rise. Our view is that while growth has been boosted by immigration, the extra number of available workers will put downward pressure on wage rates. The September retail sales figures recorded a 0.4% decline on the month, the biggest fall since January, hardly a sign of an unchecked consumer boom. Despite the likelihood of an economic slowdown, driven by downward pressure on wages, we continue to believe that the market is attractive on valuation grounds.


Budget bonanzas

At least in Europe, a notably high-tax region, the recovery in the economies is yielding unexpected bonuses for beleaguered governments. For the first three quarters of the year, German tax receipts have risen by 7.8% yoy, and the budget deficit will fall well below the 3% of GDP threshold required by Brussels a year ahead of schedule. Membership of the Eurozone was granted as much on political as on economic grounds, which is why existing members turned a blind eye to the blatant cheating practised by Italy, Greece and Portugal when they applied. Up to now the markets have ignored Italy’s failure to reform, cut its budget deficits and become more competitive, despite having benefited from the lower interest rates permitted by the European Central Bank, but their patience snapped after the latest draft budget was announced. Two rating agencies have downgraded Italy’s credit rating, which will ultimately mean it has to pay more to borrow, and investors hope that this shot across the bows will bring the politicians to heel. Since the finance minister responsible for the budget dismissed the downgrades as ‘political’ we suspect the government, like its predecessor, will continue to live down to our expectations. Nevertheless, we remain optimistic of the Eurozone as a whole and believe that growth will continue to surprise on the upside. Their equities remain attractive.

Far East

How long can the Yen remain cheap?

China’s growth is becoming monotonous – QIII GDP grew by 10.4%, while industrial output grew by 16.1%. Retail sales rose by 13.9%, powered by a strong rise in both urban and rural incomes. Indeed we expect the growing importance of the Chinese consumer to offset the US slowdown in 2007.

Indian growth is also accelerating – August industrial output rose by 9.7% yoy – despite a relatively stagnant agricultural sector, and the determined opposition of the government’s communist coalition partners to attempts to modernise the economy. Indian companies are becoming more adventurous. In the first nine months, they have spent $7.2bn on foreign acquisitions – up from $4.5bn in the comparable 2005 period, which itself was three times the 2004 figure. Tata Steel’s $7.6bn bid for Corus, if successful, would make it the world’s sixth largest steelmaker, while the leading software houses are setting up operations in European capitals to be closer to their customers. Clearly there is a lot of liquidity in Asia at present. The world’s largest IPO, for ICBC, China’s third largest bank, generated global orders of over $400bn, making the issue over 20 times oversubscribed. The fact that it the shares will be listed simultaneously in both HK and Shanghai brings forward the date at which the exchanges could be unified, and China’s weighting in global stock markets rises dramatically. Data out of Japan, however, remains somewhat disappointing, and despite the upbeat Tankan report, we would like to see some better news before committing new funds. Currency traders and hedge funds continue to borrow (i.e. sell) the Yen to reinvest in other currencies and assets yielding higher returns, depressing the Yen to levels that cannot be justified on competitiveness grounds, and undermining equity returns to UK investors. At some stage we expect this deeply oversold position to be corrected by a strong Yen rally but this is only likely to occur if the relative attractiveness of these other assets declines. This may be the 2007 story.

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 2006 Ref: 263/06

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