Over the past quarter, global equities have overcome their May setback and are closing in on their 2000 highs, despite some economic cross-currents that made the oil and mining sectors particularly volatile.
The fears of a US slowdown driven by the housing market were alleviated by the ongoing weakness in the oil price as inventories rose and the risk of disruption from hurricanes or Middle East tensions faded. The US housing market and the US economy no longer seem to be heading for a hard landing. Corporate earnings are not under pressure, and equities have become more attractive.
Global fund managers are divided about prospects. The latest Merrill Lynch regional survey shows a general consensus that the global economy and corporate earnings are slowing. Although regarding European, and especially US equity markets as undervalued, managers have lacked the courage of their convictions to run down their overweight cash positions. They should. We see further upside potential, based on a still healthy world economy, modest valuations and ongoing growth in corporate earnings. Most of all, we continue to see world markets being driven by liquidity which is fuelling merger and acquisition (M&A) activity.
USA – the cloud of unknowing
We believe that the risk of recession has been significantly reduced by the fall in both the gasoline price and mortgage rates, and 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, and share price volatility is back to a 13-year low, suggesting that investors believe that economic cycles have become less extreme. The corporate results season passed with few unpleasant surprises, and we believe the market has further upside. Investors have still to evaluate the impact of the recent Democrat victories, but this is a story for 2007.
UK – bad news as corporate tax rates likely to fall
Despite a strong third quarter GDP number, which saw the economy growing by 2.8%, this has yet to translate into a healthier budget position; the latest monthly deficit, Ł12.3bn, was the highest September figure on record. VAT receipts are still suffering from carousel fraud, but corporation tax receipts are booming, and companies are beginning to protest. Companies domiciled in the UK are trying to mitigate tax 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 the Chancellor to be generous to his captive market – individual taxpayers – few of whom are in a position to change domicile.
Meanwhile the Bank of England Inflation Report was surprisingly dovish. The Old Lady had feared that the economy is growing too fast for comfort, and that interest rates will have to rise, but has been forced to admit that, while immigration has boosted growth, it has also put downward pressure on wages – a view we have held for some time. We believe rates are now on hold. Equity valuations remain attractive.
Europe – budget bonanzas
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% year-on-year and the budget deficit will fall well below the 3% of GDP threshold required by Brussels, a year ahead of schedule.
Despite the disappointing Italian Budget, which has made two rating agencies downgrade its credit rating, and the failure of the French Government to introduce labour reform ahead of the 2007 election, we remain optimistic of the Eurozone as a whole. We believe that growth will continue to surprise on the upside – as will M&A activity.
Far East – how long can the yen remain cheap?
China’s growth is becoming monotonous – third quarter 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% year-on-year – despite a relatively stagnant agricultural sector, and the determined opposition of the government’s communist coalition partners to attempts to modernise the economy.
Clearly there is a lot of liquidity in Asia at present. The world’s largest individual public offering, for ICBC, China’s third largest bank, generated global orders of over $400bn, making the issue more than 20 times oversubscribed. Data out of Japan, however, remains somewhat disappointing, and despite the upbeat Tankan report and the undervalued yen, we would like to see some better news before committing new funds.
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