UK: Investment Management Outlook, August 2007

Last Updated: 25 July 2007

World Markets

Can They Break Out?

Since early May, leading equity markets have tried and failed several times to overcome their recent highs. The uncertainty about the extent and impact of the sub-prime mortgage problems in the USA, the mixed messages from the US economy and the general lack of direction during the summer holidays have all combined to restrain upward progress. The same has not been true, however, of Emerging Markets, which continued to attract foreign investors and moved into new high ground.

The overall global economic picture remains encouraging. China has revised up its 2006 GDP growth number from 10.7% to 11.1%, and there seems little reason to expect a significant slowdown this year. Upgrades continue in the Eurozone. We are, however, becoming more concerned about the USA, where there are signs that the recovery after the first quarter could be weak. Valuations remain reasonable across most markets, although in Asia they are pressing up against the top end of our comfort zone. The key driver of global markets remains the continuing availability of cheap credit to fuel M&A and share buybacks. Rising investment by the sovereign wealth funds – i.e. state-controlled funds created by the oil exporters and high-saving Asian nations to maximise the returns on foreign reserves – will increasingly support global equities. Despite the high level of speculative activity and rumours thereof, which we would normally regard as a danger sign, we believe equity markets will continue to climb the wall of worry.


Sub-Prime Blues

While the most widely reported monthly data and indicators suggest that the economy has merely slowed to a period of sub-trend growth for a few quarters, there is growing evidence that the recovery predicted by the leading indicators may not be as robust as the market hopes. Tax collection has been disappointing over the past six months, suggesting that the payrolls have been weaker than the official numbers. This is in marked contrast to the period up to the end of 2006, when buoyant tax collections provided a clear hint that job creation was taking place faster than the monthly payroll numbers were recording. Wage growth also appears to have peaked, highly unusual this late in the economic cycle when labour is normally tight. The Conference Board Leading Indicator has been flat for over a year, in marked contrast to the previous cycle. Early announcements by some consumer-based companies in the current reporting season were disappointing, again suggesting that demand may be less robust, and June retail sales fell by 0.9% mom, against an expectation of a rise of 0.1%. Finally, the latest Conference Board survey of business confidence showed a marked downturn in the second quarter, with only 17% of executives expecting economic conditions to improve over the next six months. Despite the protestations of the leading investment banks that the fallout from the sub-prime mortgage crisis is containable, the absence of reliable data makes investors cautious of what they cannot quantify. The housing market is far from bottoming. Foreclosure rates in Nevada reached 1 for every 166 households by May, and nationwide filings rose by 90% yoy. With a growing number of mortgages being reset at higher rates, credit lines being tightened and repossessed properties returning to the market, we may expect a further year of housing weakness ahead.

Readers should not be unduly depressed by this, however. Valuations remain modest, bond yields have fallen back, and earnings of the multinationals have been considerably enhanced by the fall in the Dollar.


Mixed Messages

A recent Manpower survey reported that British companies will accelerate recruitment in Q3; financial and business services reported the strongest hiring intentions since 1998. Despite this, wage deals remain steady, productivity grew by an impressive 2.7% in Q1, and unit labour costs in manufacturing actually fell by 0.1% yoy. According to the CBI, order books hit a 12-year high in June. Rising recruitment has boosted the tax take and reduced the budget deficit. Even inflation seems to have subsided, but we suspect that the Bank of England is looking for risks to increase in 2008 reflecting the tightening in labour supply (higher vacancies and participation rates), and possibly rising food and energy costs. More rate rises are expected – hence the strength of sterling. Against this encouraging backdrop, we note the gloomy forecasts from the Council of Mortgage Lenders, and that the growing dependence of the economy on the financial sector could backfire in the event of a credit crisis. In the short term however, the market is supported not only by valuations but also by rising oil prices and M&A activity. The unprecedented floods which have caused serious personal and financial distress, will result in increased spending on new homes and flood defences in years to come.


Still Optimistic

France’s new hyperactive President has been busy issuing policies right and left. Unfortunately he has upset the German government with his attempts to pressurise the European Central Bank into greater flexibility (something that Bonn regards as non-negotiable), his protectionism and economic nationalism, and his cavalier decision to maintain high budget deficits. These disagreements are unlikely to affect regional economic growth, which will be driven increasingly by consumption. In July, the German consumer confidence index rose close to a record high, reflecting a steady decline in unemployment to a 12-year low. The German Chambers of Industry and Commerce are the most upbeat since reunification in 1990, and while the strength of the Euro is putting pressure on engineering profits, the VDMA Engineering Association has raised its 2007 growth forecast from 4% to 9%. We believe economic growth across the region will continue to beat expectations, and that any 2008 slowdown will be modest. Inflation so far remains under control, and while we expect a further rise in interest rates, valuations suggest further upside.

Far East

A Wave Of Cash

China continues to accumulate reserves at an impressive rate, and by end-June these had reached $1.33trn. Some $200bn of this is now being recycled into a state-controlled international investment vehicle. At the same time China has relaxed the terms under which individuals and corporations can invest overseas. We regard this as bullish for global equities, and in particular for the regional Asian markets. Valuations in the region have risen significantly but given the strength of the economies and the balance sheets of the companies, further upside is expected. Six of the leading non-Japanese Asian markets have yet to pass their 1994-7 peaks

By contrast, there seems little reason to be optimistic about the Japanese market, despite the likelihood of earnings upgrades. There has been no sign of a recovery in consumer demand; the latest Tankan survey shows that corporate optimism is confined to the large exporters; the service sector and small manufacturers remain gloomy. Protectionist instincts remain strong, limiting the prospects for foreign activist funds, and it is hard to see what could drive Topix to move above the strong resistance around 1800.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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