05/06/2008
Say on pay – Grasping the Nettle
The complex nature of the US economic slowdown suggests that a rapid recovery is doubtful. Given the size and reach of the US, its impact will be felt across the globe, so an open economy like the UK cannot escape. After considering where best to invest during this difficult period, we suggest investors think carefully about the risks in the assets they own.
Earlier this year, more commentators accepted that a US recession is occurring. More recently, there has been a growing realisation that other developed economies, such as Europe, Japan and the UK, will be weak for some time. We expect overall growth of no more than 1-2% in both 2008 and 2009, versus rates of 2, 3, even 4%, seen in 2006 and 2007. As the world economy is so integrated, the next stage is appearing in the form of slower Asian exports.
The credit crisis looks more contained now. Central banks, led by the US Fed, have hurriedly cobbled together a whole series of new tools, adding liquidity to money markets, even starting down the road of effectively nationalising parts of the mortgage market. However, not many households have felt the benefits of this approach. Where official interest rates have been cut, banks have generally been unwilling or unable to follow suit. Large losses in some areas mean profits need to be made in others! The headline grabbing surge in food and fuel prices, hitting headline inflation, has ruled out future rate cuts for the time being, not just in the UK but in most countries.
The good news for a long-term investor is that value is being seen in some markets. Examples would be investment-grade corporate bonds, high yielding equities, and parts of commercial property. In certain stock markets, various companies offer a dividend yield higher than government bond yield. More analysis is needed though to see whether dividend cuts or rights issues will make such stocks less favourable.
Value is not found everywhere. When cash has been put to work, it has often gone into the previous winners, such as emerging market equities or commodities. Our analysis suggests ongoing vulnerability, for example because inflation pressures will be even more worrying in many of these countries than in Europe or North America.
Equity markets have recovered quite well from the lows seen in March. Can this continue? Investors are paying close attention to earnings statements from companies, especially indications of future profits growth. To bring about a sustained recovery in revenues, we need several conditions to fall into place. One example is easier monetary policy actually being passed on to consumers and companies. Companies’ efforts to improve the state of balance sheets, for example via disposing of assets or rights issues, have historically been strong signals that corporate repair is underway. Lastly, investors would feel much more confident if the US housing market showed more signs of stabilising. This means far less new houses being built and stabilisation in house prices – both of which appears some way off.
Markets also assume that politicians will do more to bring the credit crisis to an end. If we look back at previous banking crises in the US, Sweden and Japan, some form of public sector intervention was eventually required. On this occasion, support could entail some form of mortgage guarantees, debt purchase, or capital injections. The moral hazard and financial costs are considerable, so the intense debate in Congress about the Frank-Dodd proposals to give $300-400bn of capital to the Federal Housing Administration look set to continue until at least the summer.
Overall, we expect most financial markets to remain in a volatile cycle throughout 2008. A low-risk portfolio still looks appropriate. Currently, we favour bonds and cash over higher risk assets such as equities and property. While global bond yields have risen, the inflation backdrop suggests that they can go higher, before eventually weaker economic activity allows the Bank of England and other central banks to cut interest rates. This does not mean investors should shy away from equities altogether. We favour the more defensive markets, such as UK, US and Japan, over the more cyclical emerging markets, Pacific Basin ex-Japan and Europe. Meanwhile, property values could fall further in the short run, although we still expect them to deliver mid-single digit returns over the longer term.
Overall, investors should look at their portfolio to see where it is most at risk from the issues we have outlined. Certainly, value in many equities does exist and as long as central banks can control inflation then eventually stock markets will recover. A diversified portfolio remains prudent but with a defensive bias towards bonds, cash and lower-risk equity markets.
Guy Jubb, Head of Corporate Governance at Standard Life Investments
This was published in FTfm on 2nd June 2008.
Standard Life Investments Limited, tel. +44 131 225 2345, a company registered in Scotland (SC 123321) Registered Office 1 George Street Edinburgh EH2 2LL.
The Standard Life Investments group includes Standard Life Investments (Mutual Funds) Limited, SLTM Limited, Standard Life Investments (Corporate Funds) Limited and SL Capital Partners LLP. Standard Life Investments Limited acts as Investment Manager for Standard Life Assurance Limited and Standard Life Pension Funds Limited.
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