UK: Investment Outlook - April 2008

Last Updated: 19 May 2008
Article by Paul Garwood

World Markets

Pulling Out All The Stops

The turmoil in credit markets reached a crescendo in March, with the Fed-orchestrated rescue of Bear Stearns in the USA and shocking losses at UBS in Switzerland. Investor sentiment, however, had become so depressed, and cash balances so high that even a modest improvement in mood was sufficient to trigger a powerful short-term rally. Whether it can be sustained through the summer doldrums is open to question, given the clear signs of global economic slowdown, and IMF estimates of losses and write-downs from the credit crisis totalling $945bn. Investors can take comfort from the fact that these losses are spread across the world, rather than concentrated in a single country, as was the case in the Japanese crisis of the early 1990s. The leading central banks are also coordinating their approach to the crisis. Furthermore, private equity investors are now prepared to help refinance troubled US mortgage companies and to buy packages of distressed debt from financial institutions. On the other hand, analysts remain well behind the curve in their earnings forecasts, and we expect significant downgrades to 2008/09 forecasts in the months ahead, which have not been fully factored in by investors. If the current crisis takes longer to resolve, we may expect a few years of sub-trend economic growth ahead, and this would impact both earnings and investors' perception of what constitutes reasonable valuations. In addition, the need to recapitalise the global financial sector will act to suck liquidity from investors' portfolios, in marked contrast to 2005 to 2007, when cheap financing allowed companies to retire hundreds of billions of dollars of equity. We expect markets to remain volatile but rangebound, and with significant sector rotation.


How Deep A Recession?

Despite the emergency cut in US interest rates and the massive infusion of liquidity into the global financial system by the leading central banks, against the security of increasingly dubious collateral, the global credit crisis claimed a major victim in the US investment banking sector. Mortgage credit remains scarce and expensive and the regulator has reduced the surplus capital requirements of the two leading mortgage finance companies, Fannie Mae and Freddie Mac, allowing them to take on potentially another $200bn of mortgages. It will take time for this liquidity to filter through to higher demand and a more stable housing market. While housing starts and permits are now running at rates below completions, the level of sales remains weak, and the overhang of unoccupied homes is at record levels. The credit crisis is beginning to hit sectors beyond the housing market, including the infrastructure spending of the municipalities and townships.

The most worrying aspect of the recent economic data is the weakness of the employment component. The March non-farm payroll numbers showed an 80,000 fall, with a 67,000 downward revision to January and February data. The unemployment rate rose from 4.8% to 5.1%. Consumption is already under pressure from rising inflation; wholesale gasoline prices are 25% higher than in October. Not surprisingly, car sales in February fell by 10.2% yoy. If further evidence were needed that both rich and poor Americans are feeling the pinch, we need look no further than the falling revenues at top retailers such as Saks and Macy's and at the casinos in Las Vegas and Nevada. This in turn will lead to a slowdown in construction of hotels and leisure amenities, a strong driver of construction growth over the past two years.

While domestic demand is weak, exports are benefiting from the fall in the dollar, and this will cushion the economic downturn. We see further downside ahead in US equities, but despite dollar weakness, the returns to UK investors have exceeded those from other leading markets this year. Furthermore, as the US economy is the first to slow, it should be the first to recover... and perhaps the market with it.


Rose-Tinted Eyebrows

Signs of slowdown abound. QI construction activity was the lowest since 1996. Sentiment in the services sector fell to a 15 month low, and the KPMG/REC jobs survey showed a decline in permanent placements for the first time since May 2003, and a big shift to temporary and contract employment, suggesting firms are moving to a more flexible workforce.

The survey also shows a marked slowdown in wage demands, and as this coincides with rising food and energy prices, real household income will come under increasing pressure, and consumption will remain weak. House prices fell by 2.5% in March, and derivative contracts suggest prices could fall by 2% per annum for five years; stocks of unsold homes have shown the steepest rise since 1989, while mortgage transactions fell by 33% in February. By the same token, government tax revenue from employment, VAT and stamp duty on housing transactions will also be weak. While manufacturing output beat expectations, order books have contracted for three straight months and costs are under severe pressure.

The Budget measures were widely trailed, and the surprises were in the fine print. The Chancellor's numbers are however predicated on an overoptimistic view of global and UK economic growth. The Treasury forecasts a short, shallow global slowdown with a return to trend of 4.5% per annum by 2009. CEBR expects only 3.1% in both 2008 and 2009. While the Treasury has cut its UK growth forecast by 0.75% to 1.75-2.25% for this year and a recovery to 2.25-2.75% for 2009, CEBR is expecting 1.5% and 1.7% respectively. Even on the Chancellor's forecasts, borrowings will rise by £7bn in 2008/09 and a further £12bn over the following three years, and he will probably fail to keep debt/GDP below 40% in 2009/10. Overall, it will be a long hard grind for the economy this year and next, despite the latest cut in the base rate. Equity risks remain on the downside.


Profits Hit By Euro

The Eurozone seems to be splitting into two groups - Germany, with strong manufacturing order books and rising employment, and Spain/Ireland/Italy, over-dependent on housing construction or increasingly uncompetitive and feeling the strain of a strong euro. Our hope that rising consumption in the Eurozone could cushion the slowdown in exports and construction activity is now in doubt, and we believe that analysts are far too optimistic about corporate profit forecasts. We remain negative on regional markets, even though in sterling terms they have not underperformed FTSE this year.

Far East

What Slowdown?

China has revised up its 2007 GDP growth rate from 11.4% to 11.9%, largely on the strength of the service sector, and Q1 Foreign Direct Investment rose by 61.3% yoy. Despite falling US prime rates, which should have benefited the HK property sector, the HK market suffered a sharp decline, reflecting rising fears of a US recession and the impact of some derivative trades on private investors. At the same time the domestic Chinese A-share market fell sharply.

There has been little new to say about the Japanese economy this quarter. Even though Q4 GDP growth was confirmed at 0.9%, well above expectations, the country remains heavily dependent on exports at a time when the yen has been soaring as the carry trade is unwinding and US demand is eroding. Wages are flat, bonuses are down and inflation is rising, putting pressure on consumption. The quality of government is abysmal, with the parties continuing to squabble over the appointment of a new head of the Bank of Japan, only a week before the present incumbent was due to leave his post, and at a time of turmoil in the global credit markets.

Even though the market has never been so cheap, and dividend yields exceed bond yields for only the third time in twenty years (each previous time the market staged an impressive rally), investors are at a loss as to what would catalyse buying interest. The fact that companies, with the support of government, have loaded themselves with poison pills to resist pressure from activist investors, is a further disincentive. The strength of the yen has cushioned the returns to UK investors in sterling terms, but it is hard to see how the Index can advance if the currency remains at current levels. The combination of bad news about Bear Stearns and a strong yen pushed the Topix Index below our long-term target of 1200 before a recovery. Following this period of weakness, we believe some good value is beginning to appear in both Japan and parts of Asia - especially Taiwan and Korea - but would continue to avoid the exporters.

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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