UK: Investment Outlook – August 2008

Last Updated: 4 September 2008
Article by Paul Garwood

World Markets

Remaining Volatile

The extreme investor pessimism recorded in the two most recent Merrill Lynch surveys of fund managers and the historically high levels of liquidity finally triggered a powerful, if short-lived, relief rally in global financials when recent results of some US banks beat depressed expectations. A sudden downward move in oil prices from record highs reinforced and broadened the rally. This does not mean that we are out of danger; even though equity valuations in most markets are at historically attractive levels, this is not a typical economic slowdown. Evidence abounds that the credit crisis is affecting the real economy. Large companies are squeezing their small suppliers and banks are putting pressure on borrowers seeking scarce capital to transfer other banking business to them as a condition for receiving a loan. Interest rates are rising for loans repayable in 2009 as lenders become increasingly fearful of economic conditions next year. Regulators could compel banks to take up to $5trn of assets back onto their balance sheets, and to provide more capital against risky assets, further imperilling their ability to make loans. Investors are becoming increasingly reluctant to recapitalise banks that have either denied that they have problems or have come cap in hand for the second or even third time.

In July, the US banking regulators put IndyMac into 'conservatorship' – an American euphemism for nationalisation – making it the second-largest banking failure in American history. The US government is trying desperately not to have the status of Fannie Mae and Freddie Mac changed – in other words, it does not want to formally assume responsibility for their debts.

Falling equity markets have also reduced pension fund returns, putting pressure on companies to top up their funds to meet future obligations at a time when their cash flow is under pressure. Dividend growth may disappoint.

The economic data point to a sudden and serious slowdown across the Western economies over the past quarter, and while markets would respond favourably to further weakness in the oil price, we believe that the ongoing credit crisis and increasing evidence of the pressure on consumers would cut short any rally.


Still Slowing

Food inflation is starting to bite, with leading manufacturers looking to raise prices by 12-20%. The Fed is beginning to sound a bit more hawkish on inflation, but with unemployment rising, consumers are unlikely to be able to offset fully these costs through higher wages. The benefits of the tax rebate will be swallowed up by inflation, not by increased sales volume.

The Chicago Fed National Activity Index remains deep in recession territory, and the Conference Board Leading Indicator is in decline. Better durable goods orders and new home sales, and a rebound in consumer confidence following the fall in the oil price are not enough to turn around the economy. The downturn in the property market has left state legislatures with a $40bn hole in current year budgets, forcing them to cut jobs and services.

The results season is well underway; companies with large export sales or overseas interests have generally done well, thanks to previous dollar weakness, but those close to the US consumer have disappointed. We expect equities to remain volatile.


So Much For Prudence

Even the most myopic must now see Gordon Brown's economic miracle for the charade that it really is. His cynical manipulation of the economic goalposts to justify public sector overspend has caught him out, now that the economy is slowing or perhaps even contracting. Borrowings are set to soar well beyond his 40% of GDP ceiling, but his successor has had to make a number of U-turns that have deprived him of additional tax revenue. The economic downturn is gathering momentum. Asking prices for homes in July showed the biggest monthly fall since 2001. June's rise in unemployment was the largest for 16 years. Factory orders are weak. The number of financially troubled companies has tripled between Q2 2007 and Q2 2008, and the problems are not confined to the usual suspects – construction, transport and retail – but have extended to IT, engineering and manufacturing. With estate agents, retailers, pubs and restaurants closing, the owners of the underlying properties are under pressure to cut rents or lose tenants. Demand for business properties is at the lowest for a decade, at a time when significant new properties are coming on to the market. Ultimately, this will result in rising defaults at the banks. The latest round of utility price increases will add to consumers' problems. We see a difficult year ahead; now is not the time to try bottom fishing, even though low equity prices are encouraging bid activity.


Still Slowing

The trend of slowing growth and rising inflation is becoming well established. Q2 German GDP showed a decline relative to a Q1 number that was boosted by exceptionally favourable weather, but other European economies recorded similar declines. In Germany, falling unemployment has emboldened the unions to strike for higher wages, squeezing profit margins already under pressure from a strong euro and weaker demand from overseas. In Spain, a major property group, Martinsa, has collapsed, with debts of $8.6bn, unemployment in the construction sector is soaring and the economic slowdown will put the Government budget into deficit. Q1 construction output in Ireland fell by 21.6% yoy. Unfortunately the European Central Bank seems more concerned with inflation than growth, and is disinclined to cut interest rates.

Wage growth per Eurozone employee hit an eight-year high in Q1 of 3.1% yoy, well above productivity growth of 1%, and given the automatic wage indexation to prices in Spain and Belgium, there is a risk of inflation becoming entrenched. We remain negative on Eurozone equities.

Far East

Where's The Trigger?

Visa restrictions have hit airline and hotel bookings in Beijing, and continuing high levels of air pollution are proving a public relations problem for the Chinese leadership. Fears of a serious post-Olympics slowdown in China are overdone, however, given huge ongoing infrastructure investment, and the Government has responded to weaker export demand by slowing the rate of currency appreciation. The rest of the region continues to suffer adversely from oil and food based inflation, but while we believe this is significantly discounted in current share prices, we lack a trigger for a sustainable rally during the summer doldrums. The Japanese economy remains sluggish, but the equity market is cushioned by realistic valuations and the likelihood of increased inflows from Post Office savings.

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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