08/06/06
A time to sell or a time to buy?
There is an old investment adage: 'sell in May and go away, come back again on St Legers day', in September. Our research on seasonal trends has actually shown that such cycles have become rather more complicated in recent years, but certainly 2006 has been seen by some as an example of this old thesis. The extent of day to day volatility complicates analysis, but in general terms stock markets have experienced their worst performance since the Iraq war in 2003, in some cases the worst since 1987, with other assets such as commodities and emerging market bonds under considerable pressure.
To many occasional investors, such weakness could come as rather a surprise. In most respects the world economy looks rather well placed in spring 2006; the IMF and OECD have raised their estimates for economic growth reflecting the broadening out of industrial activity from the US and Chinese locomotives to Japan and recently Europe. Even that laggard, the UK, has recently begun to show some signs of strength, both domestically and from exports. Nor have investors had to cope with poor reports from companies. In the latest US earnings season, firms reported earnings up 14% from a year earlier, 3% ahead of initial expectations, still 10%pa even excluding energy, causing analysts to raise their estimates for the whole year. Similar reports have been made by senior management at Japanese and European firms. There is some uncertainty about the all important outlook for US monetary policy. Nevertheless, after 16 successive moves, the Fed has indicated that it is likely to pause and assess the situation.
Why have investors rushed to take profits if the fundamentals are solid? Our 'Focus on Change' analysis can help bring some order to this disorder. One of the drivers has undoubtedly been the degree of speculative interest in commodities, and the assumptions made about future demand from 'BRIC' type economies. Some commodities, primarily industrial and precious metals, have been pushed to extremes due to a mix of surging emerging market demand and excessive speculation. Associated assets became too richly priced, and a variety of concerns undermined their attractiveness at a time when parts of the world economy, especially China, had grown too quickly. A toxic mix of margin calls, volatility hedging and derivative contracts helped create 'air pockets' on the way down.
A further 'Focus on Change' question is 'What is changing?' In recent weeks, the Chinese authorities have given more and more signals that they are concerned about the impact of recent over-investment in terms of weaker company margins, the rise in bad debts, and worsening environmental damage. There has also been an important change of view by investors on 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. This year, however, Europe, Japan and a number of other countries are expected to tighten by more than the US, irrespective of whether the Fed pauses. In addition, central banks are diversifying their foreign exchange reserves away from dollars, and US mutual fund investors are more deeply committed to investing outside their domestic markets. Coupled with political pressure on the Chinese authorities to allow their currency to appreciate, the US dollar has recently experienced its sharpest decline since early 2003.
A variety of issues therefore concerned investors. Some have worried about the impact of commodities and the dollar on inflation expectations, others worried about the impact of a rise in the cost of capital on market valuations and future economic activity, while the upturn in investor uncertainty has clearly affected M&A and private equity deals.
Ahead of this recent market turbulence, our 'Focus on Change' investment process caused us to reduce risk in our portfolios, specifically by lowering the weightings towards higher risk assets such as emerging markets, raising the weightings towards bonds and especially cash back towards neutral, and protecting our portfolios from further currency volatility. This process was successful, but nevertheless some difficult questions lie ahead.
For example, is this the start of a bear market? We think not. However, we would warn that market volatility could continue for some time. One analogy is with market events in 2004, the last time the Chinese authorities acted to slow the economy. Financial assets were under pressure, from the spring into the summer, until it became clear that the slowdown in Chinese activity would not be too great. On this occasion, as well as Chinese policy making, investors need to see some reassurance on the supply and demand dynamics for commodities, the views of politicians on the US dollar, signals from several central banks, and cross-border investment flows.
It is important for investors to stand back and assess the structural drivers of the investment cycle. Two key questions are: has the era of muted inflation come to an end, and will global activity and therefore earnings roll over significantly into 2007? Our answers are No in both cases, but we are well aware of the risks. As far as inflation is concerned, our analysis concludes that that robust productivity growth and an emphasis on cost control are limiting pricing pressures. Nevertheless, there are signs that more companies are finding some ability to pass cost increases through as the business cycle is extended. As far as the earnings outlook is concerned, we are examining the dynamics of the global economies into 2007. Tighter credit costs and higher energy costs mean a mid-cycle pause looks a more likely outcome. However, we are reassured that neither household nor corporate sector balance sheets look over-extended, which in the past has been associated with a plunge in earnings.
To conclude, our House View was prepared for market volatility during the spring, and we are wary of continued disturbances into the summer. We are examining yet again some of the key drivers of financial markets, but as long as the earnings cycle appears sustainable and companies remain committed to self-help initiatives to maintain margins, then in due course riskier assets should benefit from the continuation of this elongated business cycle.
Andrew Milligan, Head of Global Strategy, Standard Life Investments
This article was first published in Professional Adviser on 08 June 2006
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