05/08/2007

Mixed messages for investors after market meltdown

Stock markets have largely gone nowhere since Monday, failing to reverse the setbacks of the previous week, as credit markets tightened. The FTSE 100 opened on Monday at 6206 and closed on Friday at 6224. The share prices of some global institutions have been hit by deteriorating bad debts, triggered by meltdown in the US sub-prime mortgage market.

In the UK, stronger than expected mortgage data points to further increases in borrowing costs in the months ahead. Against a background of more expensive borrowing costs and disappearing credit lines, much of the takeover activity which has driven share prices higher is expected to grind to a halt. Will this signal renewed Armageddon for share prices, or a helpful pause for markets to regain their senses?

Scotland on Sunday asked six of the UK's leading fund managers what investors should do next. The grim news is that we can expect a bumpy road ahead, with predictions of further market nervousness, before the dark days recede. On a brighter note, they believe many economies and companies are leaner and fitter than ever, and will ride out the storm.

John Chatfeild-Roberts, head of Jupiter's independent funds team, agrees that markets are likely to remain "skittish" until order returns to the US housing market, problems in which have left investors distinctly nervous.

He says: "Defaults in the US housing market are rising, leading to a sudden rise in the cost of borrowing. While mortgage lenders have tightened up lending criteria, investors have become much more risk averse.

"In particular, this has made it difficult for private equity operators to finance recent high-profile acquisitions."

When deciding what action to take to protect their holdings, he says investors must ask whether there has been a meaningful shift in the underlying factors that drive equity markets in the long term.

He believes not. "Economic growth and the ability of companies to grow their profits are vital. The world economy is on track for another year of strong growth, even though the US economy is still sluggish.

"Company profits are also in good shape. Overall growth in profits is slowing, after years of exceptional growth, but many companies are still managing to surprise the market. In the long run, this should be supportive for equity markets, even if takeover activity is likely to become more selective. In the shorter term, investors in many markets are likely to stay skittish."

Jeremy Tigue, who manages of the UK's oldest investment trusts, the GBP 2.6bn Foreign & Colonial Investment Trust, says today "feels" like 1987 when markets crashed, but recovered much more quickly than observers expected.

He says: "There is a clear disconnect between market behaviour and the underlying economic picture. In this respect 2007 is starting to feel very similar to 1987 when markets took a short, sharp hit, providing savvy investors with a breadth of opportunities."

He acknowledges stock markets are increasingly unsettled with "ever more erratic share price swings". He is also convinced "the cards are stacked towards a further correction."

Overall, though, he says: "Global growth remains strong, inflation under control and the emerging markets of India, China and Brazil are showing impressive resilience in the face of recent stock market falls in the developed world. We are poised for opportunities to buy into the dips."

He is sanguine about speculation of a private equity bubble set to burst. The F&C investment trust has increased its private equity exposure up from 3.5 per cent at the end of last year to 6.5 per cent with a target of 10 per cent by 2009.

Despite refinancing problems surrounding several high-profile deals, Tigue says: "There may be a bubble in certain areas of the global private equity market, such as large-scale buyout activity, but a diversified exposure both in terms of geography and sectors should protect from any serious pull-backs. With a plethora of restructuring opportunities the outlook for private equity activity remains strong."

Nicky Richards, chief investment officer of UK and European Equities at Fidelity International, advises investors not to overlook the fact that choppy markets can present buying opportunities for investors to top up holdings on a selective basis.

She says: "Investors should hold their nerve and look for buying opportunities. While the current weakness in global markets may be unnerving, the falls are relatively modest against the strong gains seen in recent years.

"The fundamental outlook for stock markets remains sound. The economic and corporate data are supportive of current valuations. US Treasury Secretary Henry Paulson's remarks that the American economy was moving to a sustainable pace of growth has been a tonic for investors.

"Corporate earnings are helped by economic growth. The recovery in the US GDP growth rate to an annualised 3.4 per cent in the second quarter, up from 0.6 per cent growth in the previous quarter, underlines this strength."

Andrew Milligan, head of Global Strategy at Standard Life Investments, doesn't underestimate the gravity of the threat facing credit markets, but believes scope remains for soundly run firms to prosper.

He says: "These are dangerous times - the largest credit event since the Russia/ Long Term Capital Management incident in 1998. More forced selling is expected as hedge funds and investment banks discover the (rather lower) true value of many of their assets. Tighter lending standards means the firepower for mergers and acquisitions and private equity activity is constrained. During market turmoil, a disciplined investment process is essential.

"Two points reassure us. Firstly, a lot of bad news is now in the price, whether a surge in corporate bond defaults or a recession in US profits. Stock market valuations are increasingly attractive, both in historical terms and in relation to the relative rewards between gilts and equities.

"Secondly, the global economy remains solid, as strength in Asia and Europe offsets the undoubted weakness in the US. Indeed, the IMF recently upgraded its global growth forecasts to 5 per cent for both 2007 and 2008. Companies are pushing through productivity improvements, enabling earnings growth of some 10 per cent a year. Yes, at the end of this crisis, riskier borrowers will face more expensive credit, but the tap remains open for mainstream borrowers, companies and the man in the street."

Bryan Johnston, senior divisional director Bell Lawrie, believes markets will remain choppy until the Bank of England eases borrowing costs.

"Investment markets usually bottom out when the last bull has finally given up in disgust, and despair is rampant. Stocks become aggressively oversold, at which point one or two more enterprising fund managers initiate tentative buying programmes. This can trigger a spectacular initial rally - January 4, 1975 was a particular example, when the index rose something like 20 per cent, albeit from 148 to 180.

"This initial spike is then usually followed by a wave of profit taking, which itself is exhausted somewhat above the previous low point. Markets then start to respond to more detailed analysis of value, which brings a progressive advance with periodic setbacks, until rampant optimism results in a total loss of reason, exemplified by the peak of the IT boom in 2000.

"At that point, someone somewhere has an attack of reality, the market suffers a setback, rallies, prompting further sales, falls back again and then finally establishes a downward spiral, which finishes on the platform of utter gloom. Then the whole process starts again.

"We are somewhere between stage two and three of this bear cycle. I suspect we shall see further weakness as the commodity cycle turns down. Still, corporate results are pretty solid and the industrial body corporate financially robust.

"However, consumer confidence is fragile... and the global political picture is singularly bleak. At some point the Bank of England will relax its grip; until then, markets will remain volatile and edgy."

Ken Adams, head of Global Strategy at SWIP, notes: "With a moderate slowing in the global economy, we expect equities to produce total returns in the region of 8-10 per cent on a 12-month investment horizon. If we were to consider all of the most likely alternative outcomes, however, equity returns may be lower. As always, stock-picking capabilities will be key in identifying companies that can add value across our range of portfolios, despite the current volatility in equity markets.

"Before the recent equity market falls, we believed that, relative to other asset classes, equities were beginning to look less attractive when considering the risks.

"The sharp correction recently has re-established some value, although there remains downside risk. Despite the significant problems we have seen in the US sub-prime mortgage markets, the consensus's sanguine view of the business cycle remains intact. On the downside however, we must recognise that this view may prove too optimistic, prompting another sell-off.

"In terms of bond markets, government gilts have performed well recently, illustrating their diversification value within a multi-asset portfolio. Continued investment in this asset class can still be justified for diversification purposes should there be any further downturn in equity markets."

First published in Scotland on Sunday, 5 August 2007.

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