Mounting Optimism In Markets

Posted on: 12 August 2008 by Gareth Hargreaves

The financial world expresses cautious optimism as markets show growth, says expert Graham Kerner.

There was a welcome break from the doom and gloom this week, as the majority of global equity markets finished in positive territory, causing commentators to start debating whether sentiment is beginning to turn.

In addition to this, there was increased positivity around the US economy as the dollar was pushed to a 21-month high against sterling, a 7-month peak against the Yen, as well as its best one-day performance in eight years against the Euro.

One of the catalysts for this optimism was comments made by the president of the European Central Bank, Jean-Claude Trichet, who stated that economic growth in the Eurozone was weakening, dismissing further ECB rate rises.

This prompted several commentators in The Financial Times to compare the outlooks of the UK, Eurozone, and Japan with that of the US, reaching the conclusions that recessions may very well have begun, but the US may be able to leave this crisis behind very quickly, citing the fact that the US reacts sharply while the rest of the world is more conservative in their potential solutions.

As mentioned, equity markets were strong with the FTSE 100 rising 2.51 per cent to 5,489.20. The S&P 500 also rose 2.9 per cent, and the FTSE Eurofirst 300 index returned 2.93 per cent for the week.

The bullish mood amongst equity investors this week was aided by the continued drop in oil prices which is now more than 20 per cent lower than the July peak. The price dipped below $115 per barrel for the first time since the start of May, amid the dollar's strong rally and growing concerns that demand would slow as economic growth contracted. The oil price continuing to fall in spite of the threat of Russia/Georgia war in South Ossetia was also interpreted as further good news.

For the developed markets, it was a welcome respite from recent volatility, but in emerging economies the opposite was happening. On Friday, the Russian market fell by more than 11 per cent to a 14-month low as tensions between Russia and Georgia escalated, and Chinese stocks ended the week at a 19-month low as the Olympics got underway amid an 8 per cent loss on the first day of the Games. Chinese shares have so far been amongst the worst performers in 2008, with the Shanghai Composite index showing declines of almost 50 per cent, as investors have fretted about higher inflation, slowing of growth and the potential impact of a US-led slowdown on Chinese exports.

Hands Are Tied

With the President of the European Central Bank stating that the Eurozone interest rates will not be reducing anytime soon, the Bank of England also held interest rates this week, though it is thought that the Committee was split three ways.

As pointed out by The Mail on Sunday, any hopes of cuts in rates will be dealt a blow this week with official figures expected to show inflation running at a 16-year high. The figures for the Consumer Price Index are expected to be more than double the Government's target at more than 4 per cent, a level not seen since May 1992, and could reach 5 per cent within another two months according to The Sunday Times. This level is being pushed predominantly by food prices and energy costs.

The Bank of England's monetary policy committee is tasked with keeping inflation below 2 per cent, and is now struggling to cut interest rates to stimulate the economy. If economists are correct and the inflation rate keeps climbing, Mervyn King, the Governor of the Bank of England, will be forced to explain to the Chancellor exactly why the Bank are missing their target by such a hefty margin.

Mr King will give his latest forecast for the economy in the Bank's quarterly inflation report this week, which will be published on Wednesday shortly after the publication of expected increased unemployment figures.

The Sunday Telegraph reported that the Bank of England was also likely to cut its own forecast for economic growth from 1.5 per cent down to around 1 per cent, which could be embarrassing for the Chancellor who is still predicting growth of 2 to 2.5 per cent over the next two years.

Looking at the opposite side of the argument, if prices are racing up uncontrollably, the normal course of action would be to raise rates, yet that doesn't seem even a remote possibility. The general consensus is that this would make the situation worse, due to already-waning consumer confidence in the housing market and retail sectors.

Dominic O'Connell in The Sunday Times highlighted how impotent a Central Bank Governor can be in the face of unexpected global events like the credit crunch. It was suggested that Mervyn King must hope to ride out the storm, because for the Bank to pronounce further doom and gloom could transfer over to the wider public, prompting aggressive wage demands launching the economy into an inflation spiral. It truly is a delicate balance.

Property Positives

One of the key aspects to outperforming through volatile times is having a fully-diversified portfolio across all asset classes.

The Financial Times reported that the Commercial Property saw net inflows during Quarter 2 of 2008, hinting that investors may be starting to see some value in the sector. The sector saw £596m of new money in, while redemptions fell to £557m, turning net flows positive for the first time in a year. The firming sentiment comes as performance continues to be weak, but yields are still rising to very attractive levels.

Good Time To Invest?

While the renewed optimism around equities is good news for most investors, The Financial Times remained cautious with their assessment, reminding readers that there are certain sectors that may have volatility to come.

The financial sector has been under the spotlight more than any other over the past year, and, even though some investors seem to be willing to buy banks again, this seems likely to continue regardless of short-term improvements as seen recently. The rebound may be short-lived, as UK banks are still facing a steady increase in bad debt from consumers and corporate customers as a result of the inevitable economic slowdown.

Where the much-publicised corporate write-downs are concerned, the UK's five biggest lenders have written off almost £20 billion in complex debt securities, but to neutralise that, three of them have raised that amount in fresh capital. Most bankers consider the worst of the write-downs to be over. Royal Bank of Scotland shares have risen 50 per cent since mid-July, Barclays shares have returned 40 per cent over the same period, and HBOS are up almost 30 per cent. This is a significant rebound, though the shares are still worth less than half of their August 2007 valuations, lighting up the eyes of the long-term investor.

Many fund managers in the industry have spent the last year investing defensively in large and mega-cap companies, and The Sunday Telegraph produced a piece debating whether the tide was turning in terms of mid and small-cap stocks beginning to look as cheap. Over the past year, the FTSE 100 has fallen 18.5 per cent against a FTSE 250 fall of 28 per cent. However, year to date, that gap reduces to around a 3.5 per cent difference in favour of the large cap stocks. While the general consensus was that large and mega-cap stocks - the top 10 companies in the UK - were still a suitable play for the more defensive fund manager, a lot of them are still cheap but not as cheap relative to mid and small-cap as they were. Of course, the size of a company is just one factor to take into account when making an investment decision.

Neil Woodford of Invesco Perpetual, lead manager of the SJP/Invesco Managed funds and manager of the SJP High Income Unit Trust, recently reported, "The funds are currently exposed to stocks which we believe can generate decent returns and provide good dividend yields and strong dividend growth, despite a challenging economic environment."

"Accordingly, the fund has substantial weightings in what are regarded as defensive sectors. For instance, companies in the utilities and telecoms sectors feature prominently in the fund. During the month, we added to a number of our core holdings at favourable levels. These included utilities National Grid, engineering company Rolls-Royce and oil & gas producer BG. In terms of disposals, we sold retailer Marks & Spencer following a disappointing trading update."

However, the message here is every size of company is likely to have their day in the sun, and the key is to have the best manager possible at the helm with the flexibility to adapt to changing market conditions. One such Manager, John Hodson of THS Partners, lead manager of several funds for St. James's Place, recently reported a cautiously optimistic message.

"There is now a feeling that the various dislocations in the world economy are at least beginning to stabilise. Although economic releases continue to point to a weakening global economy, this does now seem to be discounted in forecasts and valuations."

"In a growing number of places in the US houses are now beginning to trade again, having in some cases fallen as much as 50 to 60 per cent in price. It now looks as though the Chinese economy is beginning to slow from its very overheated state, which probably means that some of the excesses in the commodity markets will be bought back towards equilibrium."

"Falls in the price of oil not only reduce inflation fears, but also suggest a shallower recession. We positioned the portfolio for such a correction rather too early, but the last month has shown the speed at which oil prices can fall."

11th August 2008

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