Investment Management Outlook, October 2006

Second Wind After No Wind

September, statistically, has tended to produce the worst monthly returns for global equities, and we had advised investors to use the expected period of weakness to raise their equity weightings in anticipation of a strong final quarter. Our plans however, have had to be revised in the face of unexpectedly good news on the oil front that could breathe new life into the flagging US consumer. Against expectations of another torrid hurricane season, the reality has been remarkably mild, with no disruption to production from the Gulf of Mexico, while tensions over Iran’s nuclear ambitions have subsided, and BP has announced the early repair of its Alaskan pipeline. This has forced speculators to liquidate their positions in both oil and natural gas, leading to serious losses among some hedge funds. At the same time, additions to refinery capacity and the ending of the driving season in the US has boosted supplies of refined products, driving down refinery margins, and transferring further revenue back to consumers. The combination of rising spending power and falling oil-based inflation has proved heady stuff for the US equity and bond markets, which shrugged off the prospects for an economic slowdown driven by the collapse in the housing market.

We had regarded the growth of the global economy as likely to remain robust through 2007, even before the latest fall in the oil price. The rising relative importance of the rapidly growing BRIC economies, (Brazil, Russia, India, China), the recycling of OPEC and Russian oil surpluses into productive capital investment and the under-recording of Internet sales to the consumer all pointed in this direction. Indeed, growth forecasts have been steadily revised up, despite the growing headwind of rising interest rates. The fall in the oil price will underpin growth and corporate profits, while the falling bond yields will permit a rerating of equities – particularly in the USA, which has experienced two years of significant derating. Finally, lower interest rates and low gasoline prices will spur demand for the two big-ticket items – homes and cars – both of which are major consumers of steel and base metals, particularly copper. We do not share the bearishness of some commentators for these commodities. For example, the USA will account for only an estimated 12.7% of global copper demand in 2007, whereas China will account for 24.5%. In 2001, the respective shares were 17.6% and 15.1%. In 2007, the US slowdown will have a far smaller impact on the global economy than in the past, but markets have failed to recognise this, and have forsaken cyclical sectors in favour of defensive ones. Unless the geopolitics deteriorate significantly and the price and availability of oil become problems again, we believe that global equities could have a second wind.

The Dow: Knocking On Heaven’s Door

The housing slowdown continues, and while the data on existing home sales suggest that the market may be bottoming, selling prices are now below those of a year ago and the inventory of unsold units has soared to 7.5 months. The September National Association of Housebuilders (NAHB) Sentiment Index hit a level last seen in February 1991, when the economy was already in recession, a factor that will soon bear down on the level of new housing permits. Moreover, there is a strong historic correlation between this Index and consumption. The Conference Board Leading Indicator and a number of economic models incorporating the short rate and the yield curve are pointing to an increasing risk of recession within the next 12 months. The market so far is ignoring this possibility. We consider that the 2007 earnings forecasts from the sell-side analysts are unrealistically high, and expect significant downgrades over the months ahead. This however need not mean that US equities are vulnerable. They have already undergone a significant derating over the past two years, and falling bond yields make them attractive relative to bonds, even if earnings are downgraded. There is a possibility that the Dow will break its 2000 high, and even NASDAQ is showing remarkable strength.

Pity About The Fraud…

The economy continues to perform strongly, thanks in part to the contribution from East European immigrants, (who have also been boosting the buy-to-let housing market), but the Chancellor has become increasingly boxed in. Tax revenues are not growing at a rate that reflects the enhanced growth, due to ongoing VAT fraud, (estimated by Belgian researchers at £8.5bn in the year to June, a number that the Treasury "doesn’t recognise"), and to successful appeals by companies on their requirement to pay certain taxes. The statisticians have also bored a hole in the government’s accounting on Private Finance Initiatives (PFI) schemes, which, up to now it has claimed were off-balance sheet items. After five years of deliberation, the Office of National Statistics (ONS) has decided that some £4.95bn from this source should be added to government debt. This would add around 0.4% to government debt, although thanks to the recent upgrade to GDP, the debt/ GDP ratio rises by only 0.1% to 36.7%, well within the Chancellor’s 40% limit. In order to stay within his Golden Rule, the growth in public spending will have to fall from 4.8% averaged over the past 7 years to 1.9% per annum over the 3 years to April 2008. In turn, this will tighten the pressure on public sector wage claims, and we would expect to see more transfers of jobs from the state to the private sector…and more industrial disputes. But by next year, this will be someone else’s problem. The heavy exposure of the UK equity market to Oil and Mines has held back performance over the past two months, despite M&A activity, but we see this trend reversing as commodity investors become more confident that the strength of the global economy will be sustained. We also see no reason why the pace of takeovers should diminish, and while there may be more earnings downgrades, especially among companies exposed to the USA, valuations remain attractive.

Growing Despite M. Trichet

Growth forecasts continue to be raised, and this is benefiting government budgets throughout the Eurozone. The corollary is that the pressure to raise taxes is diminishing, a factor that should ensure that, in Germany at least, the proposed 3pct rise in VAT rates may not take place next year. German industrial confidence, as measured by the ifo survey, remains buoyant, and while consumer confidence is still depressed, we feel that rising employment and the marked slowdown in price inflation will progressively lift their confidence and spending through 2007. M. Trichet of the European Central Bank, like the Spanish Inquisition, continues to detect the heresy of pent-up inflation wherever he turns, but most other observers would find the accused guiltless, and wonder how long it will be before the ECB abandons its hawkish rhetoric and at least signals a pause in rate increases. While money supply continues to grow at its current rate, however, we fear that there will be at least one more increase. Meanwhile, corporate restructuring continues apace in Germany, while the Spanish construction groups are actively bidding for assets outside Spain in anticipation of an economic slowdown. Given the continued buoyancy of demand in the Eurozone’s trading partners – other than the USA – we look for continued profit growth through 2007. Valuations remain attractive, and the major equity Indices appear technically strong. We expect further upside.

Can Abe Continue The Reforms?

In Japan, Prime Minister Koizumi has now gone. His preferred candidate, Shinzo Abe, has taken his place, and has already appointed a group of generally young and like-minded ministers. He has also made an early effort to mend fences with China, in contrast to his predecessor, whose visits to the Yasukuni shrine so angered the Chinese leadership that there were no summits between the two nations during his leadership. So far, so good, but observers are warning that the honeymoon could soon be over if Abe fails to secure a good result in the Upper House elections next summer. The equity market has proved disappointing over the past few months, especially in sterling terms, as the Yen has been persistently weak. Countries with current account surpluses, such as Russia, are not keeping their reserves in Yen. Furthermore, recent economic data has shown signs of weakness across a range of activities – retail sales, housing starts and order books. It is possible that this may be a pause rather than a reversal, given our upbeat view of the global economy, but we would prefer some evidence of recovery before committing further funds.

Elsewhere, investors have shrugged off the coup in Thailand; there is no risk of contagion in the rest of the region, and markets have been rising in anticipation of falling interest rates.

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