The US Fiddles - While Europe Turns
• The US-led global recovery continues, but uncertainty over just where we are in the upturn is dominating economic discourse. The recent sideshow of a spat between Republicans and Democrats in the US, while not doing great damage to growth, is not aiding markets to regain composure.
• This uncertainty will lead to periodic volatility in equities, as we have just witnessed in emerging markets. But as the global recovery becomes more entrenched, we can expect to see more opportunities around the world.
• While the world's attention has been focused on the US, European peripheral nations have been quietly fixing their imbalances, meaning the European consumer is becoming an important driver of corporate profits.
• Europe's recovery is also helpful for the prospects of the UK. The country faces considerable political risk in the coming years; with an election approaching against a backdrop of increased left-right polarisation and two referenda that could considerably alter Britain's place in the world.
• China's economic growth is slowing but becoming more sustainable. Still, any worthwhile investments in the country are significantly overpriced, meaning there is little opportunity to tap the country's potential directly.
• Japanese exporters, facing another dose of Quantitative Easing (QE), are benefiting faster than anyone expected from a weaker yen.
• Both short-term and long-term considerations are hinting at higher prices for agricultural commodities and declining prices for raw materials.
• Increased evidence that inflation will pick up is reinforcing our view that conventional UK government bonds are still vastly overpriced.
• In the US, government shutdowns will shave off some growth this year. However, the US recovery is becoming more self-sustaining – it's still a question of when, not if, the Federal Reserve (Fed) tightens policy.
The past three months have seen the market gradually preparing itself for the withdrawal of the support measures that central banks have used to keep the economy afloat since the financial crisis, showing that while we are escaping the downturn, we are still living in its shadow. This, coupled with the budgetary bickering in the US, has left markets uneasy after a significant run – the MSCI World index is up 21.2% this year in US dollar terms.
The uncertainty over the timing of any tapering of QE, and what effect a withdrawal might have, means that long-term profit potential isn't yet fully priced into many markets, leading to openings for those of us who strongly believe in the positive prospects for companies as the economy improves. At the same time, any periodic short-term volatility provides us with a tactical opportunity, such as the sudden and indiscriminate decline in emerging-market shares at the start of the summer. With markets fixated by what is going on in the US (similar to the obsession with the euro two years ago), there is plenty happening away from the spotlight that will create chances for investors in coming months and years.
If ever there was a case of accepted wisdom being significantly out of tune with reality, a strong contender must be Europe and the survival of the euro (we've been wary of those predicting euro doom for many years). Over the past three or four years, pundit after pundit was lining up on television, in newspapers and on financial blogs predicting the demise of the euro and the collapse of its most indebted nations. Against this polemic, it seems an understatement just to say that what they predicted has not happened. Europe is still functioning well, no one has crashed out of the euro and the currency is still one of the main world reserves.
As the graph below demonstrates, the Eurozone is growing its gross government debt to Gross Domestic Product (GDP) slower than both the US and the UK.
Source: SW Mitchell Capital, Eurostat, Berenberg
The fact that confounded many commentators is Europe's ability to adapt. True, the single currency means that countries cannot simply devalue their way out of debt crisis as others with their own currency are able to do (the Bank of England under Mervyn King was quite blatantly talking down the pound). Instead, Europeans in Ireland, Spain and other peripheral nations have had to make themselves more competitive by cost and wage reduction and through lowering their prices. This has been aided by a new sense of reality on the part of the region's leaders – a case in point was the Spanish government's tacit support for the management of Iberia in a recent wage dispute with staff.
The reward for this discipline has been a significant turnaround in economic fortunes. Ireland officially came out of recession in the second quarter. In Spain, exports are set to grow by 4.1% this year and the country posted its first ever trade surplus in March.
Source: SW Mitchell Capital, Datastream, Markit
Europe has been given an added boost of clarity by the re-election of Chancellor Angela Merkel. With Germans acting as paymasters to rebuild the European economy, the election can be seen as a ringing endorsement of her use of the carrot of financial support for peripheral nations, and the stick of insisting on reforms. There will be more crises along the way – one need only look at Silvio Berlusconi's recent shenanigans in trying to bring down Italian government. The fact that he didn't succeed, due to a revolt among his party members who were able to distinguish between the country's long-term needs and short-term political expediency, shows just how far Europe has come.
Given the lacklustre growth in Europe in recent years, we have until recently been using the continent's luxury goods manufacturers mainly as a proxy for investing in an overheated Chinese stockmarket. There is, however, now an investment case for taking advantage of the likelihood of rising European domestic consumption as the debt crisis recedes further into the distance.
The UK's relationship with the European Union remains a political football. With a debate so clouded in Euroscepticism, an under-appreciated source of the UK's recovery (the British economy grew by 0.7% in the second quarter) is the increasing health across the Channel. With 50% of the UK's exports going to the European Union, it should really be no surprise that Britain is somewhat dependent on its fortunes.
It's also fair to say that the tentative turnaround in the UK is being helped by government and central bank policies – we strongly supported the Help-to-Buy programme as a way of using the housing market to prime the economy. But like the global recovery overall, the messages coming out of the UK are mixed. While prospects look better now than they did six months ago, we remain aware that the government has not managed to cut the country's borrowings, and is still running both a current account and budget deficit. The UK's total debt, combining the borrowings of both its citizens and government, is higher than that of Italy, Spain, Portugal or Greece when measured as a proportion of gross domestic product.
However, the biggest risk we feel for the UK now is political. The 2015 election is still to play for, with David Cameron's Conservative Party tacking further to the right on Europe, and Ed Miliband veering sharply left as he seeks price controls on energy companies. The proposed referendum on EU membership in 2017 could wrest the UK away from its largest trading partners, while the Scottish referendum of 2014 could cut the UK in two. It's an axiom that markets dislike uncertainty – to call the next few years for the UK uncertain would be an understatement.
Our views on China are nuanced, reflecting the subtle changes that are taking place in the world's second-largest economy. The first thing to note is that China, like the United States, is a driver of the global economy. Its meteoric rise has boosted the fortunes of many companies around the world who have helped build its infrastructure and sold goods and services to its increasingly wealthy citizens.
China is also a tightly managed economy, and the country's leaders are painstakingly moving the nation away from its position as a low value-added manufacturer into a country that more resembles a developed nation. As a result, the era of double-digit growth is over and gross domestic product should now increase at a more sustainable level – the World Bank recently reduced its 2013 forecast to 7.5% from its April estimate of 8.3%, while in the past 10 years it has only slid below 9% once.
This does not mean we are negative on China's prospects – far from it. A more sustainable rate of growth, and an economy less based on a building boom and more dependent on middle-class consumption is a more viable long-term economic model. Unfortunately, various factors have combined to make the shares of Chinese companies extremely overvalued, not least of which are restrictions on the Chinese investing abroad.
Valuing a Chinese company is also fraught with danger. In an economy growing this fast, should any analyst forecasts be out by just a fraction of a percentage point, that's the difference between a significant investment profit or loss. In such an environment, it does not make sense to buy into these securities. Instead, we have tapped Chinese growth potential by buying some of the shares of European companies that sell into the region and we will continue to do so.
QE has transformed Japan as an investment destination. In particular, we have been surprised at how quickly the yen has declined. Over the past year the US dollar has gone from buying 80 yen, to close to 100 yen and this has fed through into company profits – not only do Japanese exporters find it easier to sell their goods abroad because they are now cheaper in foreign-currency terms, but when that currency is translated back into Japanese yen it's worth more, producing a double-edged boost to earnings. We may even see some of Japan's electronic titans, who have been losing market share to competitors from South Korea, regaining some lost ground.
We were positive on the prospects for the US when many others were writing the nation's economic obituary. While we're still positive on the country's long-term prospects, data will continue to be mixed in coming months (recent statistics showed house prices rising and consumer confidence falling) and this will drive the debate within the Fed about when to withdraw QE. Another source of uncertainty has been the stand-off between the Democrats and Republicans over the budget and debt ceiling. We don't think this episode will do more than just slightly damp growth for this year, but considering the nation came so close to a possible default, the altercation may have some longer-term consequences for market confidence in the US.
The fact that the economic recovery is still neither clearly visible nor fully sustainable must weigh heavily on the mind of Fed Chairman Ben Bernanke. The central bank's decision not to taper QE in September confounded the predictions of commentators who'd been swayed by increasingly hawkish rhetoric from the Fed in the previous three months. The decision to delay this will make markets even more jumpy when the inevitable tapering finally does start. Although we think the Fed should have undertaken some token reduction of about $5 billion (it is still buying $85 billion every month), we can understand the reticence. The irony is that 'forward guidance' on tapering was designed to calm rather than exacerbate market nerves. The one point that is clear is that the US central bank is happy to change course even if there may be a loss of face as a consequence.
Since early summer, the Fed has been hinting that tapering will end soon and its talk may have been a tad too successful. US yields have risen significantly at the long end (where US homebuyers borrow), putting a significant dent into mortgage financing, culminating in 1,800 lost jobs at mortgage lender Wells Fargo. Bernanke's academic career focused on the study of the great depression and the authority's inadequate support for the economy, extending the length and depth of that slump. He won't want the US to make the same mistake twice, however, we still strongly believe that the US will be the first western economy to taper and to increase interest rates.
We remain negative on most hard commodities for both long-term and short-term technical reasons. Over the long-term, China is slowing the building programme that has driven high prices for commodities over the past decade. In the medium term, an advancing US dollar pushes down the value of commodities in dollar terms. Some of our value managers are now starting to see value in mining and resource companies which look relatively more attractive and where expectations are very low.
A better bet we think is in agricultural commodities. In the short term, the cycle for crops is close to the bottom – a bumper harvest due to relatively benign weather has produced an abundance of grain, which lowers prices. In response farmers will tend to sow less in the coming year, which should drive prices higher again. In the longer term, increased demand in the emerging markets for meat, the production of which uses a higher proportion of grain, will stretch prices further.
Government & Corporate Bonds
We remain very negative on government bonds – the prospect of tapering and higher rates in the US has shown the direction they'll take once a tighter policy regime comes about (Treasury 10-year yields have risen from 2.1% to 2.6% since the start of June, while UK 10-year gilts now yield 2.7%, up from 2.1%).
A decline in labour participation levels (which took the sheen off figures that at first glance showed a positive decline in the US unemployment rate) will eventually lead to a simple case of restricted supply pushing up prices – in this instance the fewer workers available for work will increase bargaining power with management. We believe this will ultimately lead to wage increases that contribute to increasing inflation, which ultimately lowers the fixed value of bond payments. With the widespread use of social media rife anyone who believes that the workforce have lost their bargaining power on the back of reduced union membership may be in for a surprise.
Our concern for higher quality corporate bonds is even stronger, given the stretched valuations that have arisen as demand for higher-yielding securities outstripped supply amid the ultralow interest-rate environment.
• Given our strong aversion to conventional government bonds, we continue to avoid most forms of conventional fixed rate securities and invest instead in inflation-linked assets such as Treasury Inflation Protected Securities (TIPS).
• We invested in emerging-market equities as a tactical ploy during the decline over recent months. Given that they have almost recovered those losses, we are also looking for opportunities elsewhere. Imbalances in countries such as India and Indonesia have led to an aversion to emerging-market debt, justified in the case of those nations, but not in places such as Brazil, where 10-year government bond yields in local currency have increased to an attractive 11.7%.
• The slow and steady recovery in the US has attracted an influx of investment in recent months, particularly for larger Standard & Poor's 500 index stocks, which are now showing signs of being overvalued. Although we remain positive on the outlook for the US economy, it might be time to deploy money currently invested in large US stocks elsewhere.
• We remain cautious about the outlook for commodities where prices have had a strong negative effect on the valuations for mining and resource companies, which have a disproportionately high presence in the UK stock market (Rio Tinto shares have fallen 7.8% this year). The decline in their fortunes means they have dropped off the radar of those investors who search for growing profits. Some of our value managers who invest in undervalued UK equities, however, are now starting to take advantage of these low prices.
• We are looking to increase our European equity exposure. A particularly underappreciated part of the market is those companies that are paying significant dividends, and we are buying some of these securities, where appropriate.
Haig Bathgate, Turcan Connell Asset Management
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