29/05/06
Have financial markets been 'priced for perfection'?
Investors hurried to take risk off the table during May. At first sight, this is peculiar. After all, global economic growth is robust, with a noticeable broadening out of activity from China and the US into Japan and more recently Europe. Stock markets are priced off current and future profits. In the latest US earnings season, companies reported profits up 14% from a year earlier, still 10%pa even excluding energy, causing analysts to raise their estimates for the whole year. Lastly, investors have been focused on the all important outlook for US monetary policy. After 16 successive moves, the Fed indicated that it is likely to pause and assess the situation.
If the fundamentals are so good, what has upset investors? The answer is that some assets were too richly priced, and a variety of concerns have undermined their attractiveness at a time when parts of the world economy had grown too quickly. Our analysis starts with the US dollar. During 2005, the US currency was supported by a mixture of helpful interest rate differentials, Asian central bank purchases of US debt, and capital flows back into the US by companies taking advantage of tax changes. Now, however, other countries are expected to tighten while the Fed pauses, central banks are diversifying reserves away from dollars, and US mutual fund investors are more deeply committed to investing outside their domestic markets. Coupled with pressure on the Chinese authorities to allow their currency to appreciate, the US dollar has recently experienced its sharpest decline since early 2003.
China is important from another point of view, as the economy has grown too rapidly and needs to rebalance. Some commodities, especially metals, have been pushed to extremes due to a mix of surging Chinese demand and excessive speculation. Bond investors have worried about the impact of commodities and the dollar on inflation expectations. Equity investors have worried about a rise in the cost of capital, both in terms of market valuations and the dampening effect it could have on future economic activity as well as M&A and private equity deals.
Where next for financial markets? This volatility should continue for some time. How and when the Chinese authorities will respond is more uncertain than the last time they acted in 2004, while the Federal Reserve awaits further data to determine next steps. Earnings reports will be affected by recent events, such as currency volatility. It is important therefore for investors to stand back and assess the structural drivers of the investment cycle.
Two issues are key: inflation and earnings. There are pressures on both, for example from commodity prices or tighter labour markets at this phase of an extended business cycle. However, our analysis still indicates that robust productivity growth and an emphasis on cost control will limit core inflation while allowing positive profits growth into 2007. Central banks will tighten monetary policy, but need not do so aggressively as the forces of globalisation keep underlying inflation in check. Our measures of global liquidity remain supportive for portfolios maintaining a positive stance towards risk assets, although this issue does require monitoring. Of course, investors need to pay attention to valuations. Some assets were expensively priced in the spring. However, when looking at most equity markets, stocks continue to look favourable on a longer-term basis as long as the earnings cycle appears sustainable and while companies remain committed to self-help initiatives. Our investment process caused us to take risk away from our portfolios in the spring; as long as these structural drivers remain supportive then we will look for attractive investment opportunities during this period of volatility.
Andrew Milligan, Head of Global Strategy, Standard Life Investments
This article was first published in Investment Adviser on 29 May 2006
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