Emerging Disappointments

I was 6 years old when Emma Taylor broke my heart. It was a classmate's birthday party, and the back garden had been decked out with all the main attractions of a playground. Much amusement was had by all but, despite the other guests’ best efforts; it was I that had demonstrated superiority on both the climbing frame and the swing. As the day came to a close, however, events moved in a much more complex direction. Each reveller was given a balloon to take home and in what was fast becoming tradition, provided you were brave enough, that balloon would be gifted to the target of your affections. A lack of preparation on my part on how to affect this potentially life changing moment, resulted in delay. This in turn created a window of opportunity for the much adored Paul Bush to pounce. It was a perfectly executed handover; gentle and selfless. The moment had passed and with it my first opportunity for love.

It was a harsh lesson for a young boy, but from that day I vowed never again to be caught off guard at the end of a party. Socially it may have resulted in some rather over ambitious efforts, but in the work place it has fared me much better.

The latest party to come to an end is in the realm of emerging market fund selection, with the two perennial outperformers (Aberdeen & First State) both making soft-closure announcements this year. For the ill prepared this presents two major problems. Not only do two other strong candidates need to be sourced but the case for replacing them with the next best 'similar' strategy is starting to look challenged. The issue stems from both First State and Aberdeen having a quality bias which, as a result, has steered them toward the more defensive growth areas such as consumption. These sectors have enjoyed a substantial rerating versus the more cyclical (economically sensitive) and 'cheaper' parts of the market, and now look optically expensive.

But before we explore this further, let’s take a look at the valuation case for emerging markets as a whole, using the P/E ratio*.

Source: Bloomberg

This chart highlights that the average valuation of emerging market companies is slightly below fair value, which appears encouraging. But then did you hear the one about the man who had his head in the oven and his feet in the freezer? On average his temperature was fine.

I think a very similar situation exists in emerging markets. The following chart measures the P/E ratios* of a basket of emerging market growth (and arguably cyclical) sectors** versus a basket of emerging market growth (and arguably defensive) sectors*** - using current market weightings.

Source: Bloomberg

The above chart highlights the extremity in valuations between the cyclical and defensive sectors, and goes some way to explain the staggering levels of out performance delivered by Aberdeen and First State.

A key driver behind this move has been the continued uncertainty in regard to economic growth and a resulting flight to quality. However, this is purely a cyclical issue - fundamentals suggest there are structural drivers at play too. In fact, even if global growth picks up, given these structural issues are so deeply entrenched, describing the cyclical sectors as 'cheap' perhaps misses the point.

The cyclical areas of the market are dominated by energy and materials companies that, in the main, are tools of state. Management focus, therefore, is typically geared toward helping government achieve full employment, rather than maximising profits for shareholders. The same can also be said for many financial companies (though to a lesser extent), often instructing credit expansion to help achieve growth targets and, frequently, with scant regard for the viability of the project. (Further elaboration on some of the structural headwinds facing emerging markets were discussed in the recent blog Go Jonny Go.)

As a result of these issues, we cannot envisage cyclical companies forming part of a buy and hold strategy and, instead, more likely represent trading opportunities. This approach, however, comes with a higher degree of risk and is something we are less comfortable with our managers executing upon. Instead, we would prefer fund managers to maintain a bias to the higher quality companies and, in that regard, our core emerging market fund replacements, continue on the path trodden by Aberdeen and First State.

I must also add that whilst the party may be over for fund pickers, clients can maintain existing holdings and can continue to benefit from the strength of the Aberdeen and First State propositions. What is more, whilst Aberdeen has already soft-closed, First State will not do so until 7th September 2013.

Ben Gutteridge

Divisional Director - Research

*Current Price divided by trailing 12 month earnings
**Cyclicals: Energy, Financials, IT, Materials, Industrials
*** Defensives: Consumer Staples, Consumer Discretionary, Telecoms, Healthcare, Utilities

The above categorisation is certainly up for debate, but we would argue that EM consumption is a structural growth story and, therefore, both staple and discretionary sectors can be considered defensive.

Un homme de nos jours (A man for our times)

Image: via Flickr

It has been a tough year for the President of France, François Hollande. Having been elected as candidate for the PS (the French socialist party) after a bruising battle against his ex-wife, Ségolène Royale and the Mayor of Lille (and daughter of Jacques Delors), Martine Aubry, he successfully defeated Nicolas Sarkozy, the diminutive incumbent, in the Presidential Election. The French presidency has been described as the only democratically elected monarchy in the world - typically  he or she enjoys more power than almost any other democratically elected leader. In fact, as an aside, this statement is quite literally true as one of the titles of the President of France is Co-Prince of the Principality of Andorra, the landlocked nation lying in the Pyrenees, traditionally founded by Charlemagne and where the official language is, uniquely, Catalan.

Anyway, enough of these amusing diversions, let’s get back to the plot. It was a case of so far, so good for Monsieur Hollande. Elected with a popular mandate to undo the reforms of Nicolas Sarkozy, with a supportive parliament and the necessary political power, the scene seemed set for radical action as François Hollande brought all of his executive experience to bear on the undoubted problems facing the French economy. Ah…there’s the rub. Aside from a period as Municipal Councillor for Ussel (no, I had to look it up too, to find it is a rural area about 50km from Clermont-Ferrand), the rest of his time has been spent as a career politician. This rather colourless background and lack of “operational” experience (for want of a better word) has led the French to give him the nickname “Flanby”, a type of wobbly, beige, somewhat bland and very sugary dessert.

His first year has been characterised by a lack of control over his own ministers – some of the diatribes from Industry Minister and left wing firebrand Arnaud Montebourg have made the wider campaign to “sell” France as an investment proposition to multinationals challenging to say the least. There has been the revelation that his budget minister, Jerome Cahuzac, had a secret Swiss bank account. Add to this mix the furore surrounding the 75% tax rate, an unseemly spat between his partner and ex-wife carried out via Twitter and the latest iTax proposition to levy a duty on all multimedia devices. I could go on, but already pressure is mounting on him to install Ségolène Royal and Martine Aubry into senior positions within his government. This has all rather reinforced the impression of a country not altogether happy with itself. Some might argue that this is a natural state of being for the French, but in the meantime François Hollande looks like being the least popular ruler of France since Louis XVI. In the meantime, following on from the unlikely, unexpected and unlooked for return of Silvio Berlusconi in Italy, who would rule out the return of Nicolas Sarkozy in France?

Rob Burgeman

Regional Director - London

Even the hardcore rocks…

Today saw a number of eurozone Gross Domestic Product (GDP) reports.  The headline was of continued eurozone recession (-0.2%) but there was a lot of information to be gleaned from the individual country performances.

Schadenfreude? The German economic miracle is tarnished (Source: ZEW/German Federal Statistics)

All eyes were on Germany which is the ‘hard’ core of the eurozone.  Recent evidence has shown the economy begin tipping into the mire with other parts of the union.  Yesterday the ZEW survey revealed a very bleak assessment of the current German economic situation from businesses.  We also saw weak wholesale prices following on from a sharp decline in consumer price inflation last month.

German GDP was expected to rebound 0.3% from a weak fourth quarter of 2012. In fact it was just 0.1% up, and that was based on a revised-down fourth quarter – dare we say it? Within a whisker of a double-dip recession (which may yet be confirmed by revisions).

…the rest of the core is soft too
If Germany is the hard core then France is the ‘soft’ core and the news there was disappointing too.

France had been expected to recover from a -0.3% decline in Q4 2012 to a -0.1% decline at the start of 2013, but fell -0.2% instead.

Oo la la! Consumer prices and growth weakening in France (Source: Eurostat)

France also reported weaker consumer prices both in absolute terms and relative to expectations (year-on-year French prices rose just 0.7% versus expectations of 0.9%).  These numbers chime with the trend of weaker CPI prints from the rest of the eurozone and, more broadly, the world.

The rest of the core was pretty pedestrian too. The Netherlands remained in recession reporting -0.1% shrinkage – in line with expectations.  Meanwhile, Finland provided some indication that its weakness is moderating, although the country is already in recession and retail sales dipped.  Austria posted unchanged GDP growth which, again, was roughly to be expected.

Finnished? Not quite but retail sales and growth remain weak (Source: Finnish Statistics Office)

A perfect storm?

The story here is one of economic convergence in the eurozone.  Why is it happening? For a number of reasons.

Germany’s great strength has been its export sector, not just in terms of the mix of goods, but also in terms of the mix of destinations – China being the jewel in the German export portfolio crown.  With Chinese data continuing to suggest more subdued growth, German businesses are likely to feel that weakness.

Just as demand is weakening, so supply may be starting to become more competitive.  Germany, as an export-orientated economy, competes with Japan in a number of automotive, electronic and industrial sectors.  That means the dramatic increase in currency competitiveness which Japan is achieving through the devaluation of the yen risks creating a perfect storm for Germany.

 

The euro is weaker and equities fell after the GDP results were published, but hopes of further policy stimulus seem to have maintained the ‘bad-news-is-good-news’ mantra.  Overall, markets see these numbers, coupled with weaker inflation figures, as offering the perfect excuse for the European Central Bank (ECB) to ease monetary policy.  The question is whether the current discussion of negative interest rates turns out to be a genuine policy option, or an example of slight of hand by ECB President Draghi.  With the suggestion having also been mentioned by the Bank of Italy governor, Ignazio Visco, the proposal is looking increasingly serious.

In the periphery conditions remain weak but the pace of decline is slowing, fitting with the theme of economic convergence.  Italian GDP, having slowed -0.9% in the final quarter of last year, lost a further -0.5% this year – cold comfort indeed. The Portuguese and Greek economies all saw sharp rebounds in their growth – from -1.8% to -0.3% in Portugal and -2.8 to 0.2% (positive) in Greece. 

Soft core...growth rates converge in the eurozone (Source: Eurostat)

The ECB will need to start easing soon and that is going to mean a very strong monetary environment.  If no further stimulus is forthcoming then markets will be disappointed.  On the other hand, provided the ECB meet expectations, what will be the new investment mantra?

“Don’t fight the Fed, or the Bank of Japan, or the ECB…”

Guy Foster

Head of Portfolio Strategy

Boom or bust for UK house prices?

Image: via Flickr

Recent weeks have seen polarised headlines warning of a rash of home repossessions or higher house prices. Whilst these two events are not mutually exclusive, the risks seem to be overstated given current financial conditions.

The housing bears have become rather preoccupied with the interest rate cliff which awaits interest-only mortgage holders when their current fixed-rate or discounted-rate terms end.

Alternatively the housing market bulls have noted the existence of schemes such as the ‘Help to Buy’ and ‘Funding for Lending’ schemes which provide potential support for the property prices.

Overall, we come down on the bullish side, buoyed by the strength of key indicators that we follow. Although it is hard to get carried away by the potential gains from UK property, it does have some of the same features of the US housing market recovery:

Source: Nationwide/HBOS

• The UK housing market has fallen. It fell just around 20% between 2007 and 2009. By contrast the US housing market fell over 30% between 2006 and 2012. 
• These falls have improved affordability which has retraced from its cyclical highs to its long term average. US housing, by contrast, has become more affordable now than at anytime in its past. 
• The drivers of affordability are house prices, wages and interest rates. As we have regularly lamented, wage growth in the US and UK has been weak and that has held back affordability. In the US, however, mortgage interest rates have been forced down by quantitative easing. In the US, Federal Reserve purchases of mortgage-backed securities pass automatically through to long-term mortgage rates and consumers are free to refinance at those rates. In the UK, that relationship between conventional QE and mortgage rates does not hold but the Bank of England’s Funding for Lending scheme does seem to have lowered mortgage rates. 

All of these factors reflect weak-form versions of the factors supporting America’s full-bodied housing market recovery. While they may not indicate 10% per annum price growth as the US is close to achieving, an improvement in house prices still has the potential to support the UK’s nascent recovery.

Higher house prices aid consumption through their wealth effect (they make people feel richer and provide access to credit). The impact on incomes is more nuanced as higher house prices reduces loan to value ratios, potentially opening up lower mortgage rates to borrowers. They also reduce the incentive for savers to make mortgage overpayments. Overpayments have been a meaningful drag on consumption since the crisis.

Source: Bank of England

We believe a key component of the UK’s economic recovery needs to be a recovery of consumption. Investment is likely to remain weak while the global economic output remains jaded. Government spending clearly retains a tightening bias regardless of the plan A/plan B debate and the structure of UK industry, coupled with weak eurozone demand, means an export-led recovery is not achievable in the short-term. Giving consumers the wealth and incomes with which to consume therefore represents an economic priority.

The ‘Help to Buy’ programme has increased the number of first time buyer enquiries - this has been consistent feedback from our equity analysts’ meetings with the banks, house builders and home improvement retailers - but it is too early to see now whether that is feeding through into higher housing activity.

However the shallow trend of higher house prices remains in place and even the depressed level of mortgage approvals supports the view that activity is recovering slowly.

Source: RICS/HBOS

The RICS house price balance released today is another good leading indicator of house price moves and it too supports the view of a recovering market.

Anecdotally we may yet hear of borrowers struggling to transition from discounted mortgages to standard variable rates but there are tailwinds for them too:

• Three years of mortgage overpayments and stable prices leaves the nations stock of housing equity in reasonably sound state. 
• Save for any change in monetary policy it remains likely that mortgage rates will remain low or fall further over the coming months. 
• Any investor who had a repayment vehicle in place to meet their interest only mortgage will have done particularly well given the strength of equity and bond markets over recent years. 

Housing returns are unlikely to return to boom times anytime soon but we feel they will be a positive driver of economic activity this year and next.

Guy  Foster

Head of Portfolio Strategy

Oriental Express...

Japan continues to light the path for equity market. The breathtaking performance of Japanese stocks reflects the dramatic influence monetary policy can have on asset prices. Japan is the best performing major market month to date and, in yen terms, the Nikkei is up 70% since the mid-November unofficial launch of Abenomics (but still down -27% since the beginning of 2007).

Since November the year-on-year expansion of M2 money supply has risen from 2.1% to 3.3%, while M3 has risen from 1.9% to 2.6%[i]. Are these monetary factors having any impact on the underlying economy? March saw the first potential signs of a narrowing of the trade balance following the Abenomic 20% fall in the trade-weighted yen. The improvement in inflation, however, is barely perceptible. Consumer prices fell -0.7% over the year to April 2013 but, on the positive side, that is a faster pace of decline than wages are suffering, which hints at an improvement in purchasing power. These are volatile data and so it remains to be seen whether real incomes can rise meaningfully.

Japanese retail sales growth remains negative. With wages falling slower than consumer prices, higher input costs (because of the yen’s depreciation) and retail sales contracting, corporate margins look increasingly stretched. More positively, overseas profits translated back into yen will be inflated by the weak currency, and sensible Japanese companies will have hedged their input prices to some degree, supporting profits until domestic sales grow.

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[i] M2 is a narrow definition of money as cash in circulation, on deposit, or reflected by certificates of deposit. M3 incorporates deposits at savings institutions.

Clearly opaque...

Today saw the release of US retail sales which were better than expected. The good news was broad, suggesting that lower commodity prices and higher house prices are providing enough relief to consumers to counter the higher taxes and lower fiscal spending they are suffering.

There are signs, therefore, that QE is not just providing liquidity to keep asset prices afloat (as a disturbing amount of press speculation has asserted recently). We can see fundamental evidence to support the logic that lower mortgage rates mean higher disposable incomes.

We have frequently discussed the underlying strengths of the US consumer (driven by positive wealth and income effects) and the manufacturing sector (driven by the shale gas revolution). The tentative evidence of today’s retail figures is that these forces may be stronger than we had thought.

In addition to today’s retail sales we have industrial production, housing numbers and the Empire manufacturing survey due this week. These will be closely watched because the question of when the US will unwind its monetary stimulus continues to loom large over the markets.

Source: Bureau of Labor Stastics/Census Bureau

Last week the Wall Street Journal polled economists and found a slim majority expecting the pace of purchases to be reduced during this year. We, however, expect it to continue unchanged. The main threat to our thesis is not the fall in the unemployment rate (as this reflects a falling participation rate rather than tightening labour conditions). Instead, we see the signs of excess in certain parts of the credit market - the boom in single B high yield bond issuance - as the main factor that might give policymakers cold feet.

Nevertheless it seems the Federal Reserve is planning an exit strategy and while the timing remains uncertain we understand that its committee members plan to reduce the pace of purchases somewhat erratically to prevent the market from positioning ahead of policymakers by, say, quickly shorting treasuries and MBS. In short the communication point that the Fed will be looking to put across to markets will be that speculators will not be able to predict the pace at which stimulus will be withdrawn.

An initial token reduction in pace would be a sensible way of implementing this strategy. Otherwise, should inflationary pressure build, or employment soar, or the dollar collapse, the Fed could be forced to slow purchases fast, in which case there would be little that could be done to persuade the market otherwise.

Life after QE?

To be clear, we don’t think those things will happen. We expect that sequestration, the mandated cuts to US federal spending, will be enough to keep inflationary pressures muted and employment growth tepid for the rest of this year. Today’s retail sales figures provide a modest challenge to that thesis, but still not one which would hint that monetary policy is too loose.

Guy Foster

Head of Portfolio Strategy

Go, Jonny, go

After a ‘man-of-the-match’ display at the weekend in what has become club rugby’s pre-eminent competition, The Heineken Cup, the case mounted for Jonny Wilkinson’s inclusion in the British & Irish Lions squad, set to tour Australia this summer. The heightened debate centred on the concern that Jonny’s inclusion would displace another emerging star (Owen Farrell) from the opportunity to tour and, therefrom, gain valuable international experience. Having already retired from international rugby in 2011, Jonny’s selection would be as a match winner, not as a means to help develop his talents for future tours.

Having played a crucial role in our inaugural rugby fixture (and victory) against Rathbones in 2012, I feel my opinion carries some weight. I am of the belief, therefore, that Jonny should have been selected. Though unlikely to merit a starting berth, his ability to come off the bench and slot crucial points may have proved vital in what are likely to be the tightest of test match fixtures.

Within an investment portfolio I am of the same view; that emerging strategies should be making way for the more developed options – in particular the US.

As has been discussed on the blog on many occasions, the US remains our favourite equity market. However, would we not expect the strength of the US economy to prove a catalyst for emerging market performance? Our conclusion, based on some of the following points, leads us to believe that US growth will not be sufficient to lift emerging markets out of their current malaise.

Source: Bloomberg

• Strong US economy - strong dollar
Recent weakness in economic data suggests the Fed closure of its ‘QEternity’ programme of $85bn monthly asset repurchases, has likely been put back. However, longer-term trends in the housing and jobs markets suggest the US remains on a sound footing toward a self-sustaining recovery. If we combine this with the recent US shale energy boon, and the improvements it will make to the trade deficit, the US dollar is primed to put in a stronger decade than the last.

As the chart above highlights, a weaker dollar has historically had a reasonably tight relationship with stronger commodity prices. Emerging markets, of which so many are commodity producers, have been the beneficiaries of such a relationship, boosting their national incomes and their propensity to spend. This is further highlighted in the performance of the MSCI Emerging Markets Equity Index.

On this basis, anything other than a weak dollar would mean flat or falling commodity prices. This is not necessarily, however, of detriment to all emerging market economies. Countries such as Turkey and India possess very little in the way of commodities and, as such, run large current account deficits to help maintain growth rates. On balance, however, falling commodity prices would be a negative multiplier for emerging market performance.

• Slowing Chinese Demand
Whilst China’s economic performance still remains remarkably strong, it is clear the pace of growth has begun to slow. The dominant components of these growth numbers are also likely to be less resource-intensive on a longer-term horizon, as the economy re-orientates to a more sustainable balance of services and consumption. Admittedly, fixed asset investment still has a huge role to play in the development of the Chinese economy. This is particularly the case in building sustainable economies in the hinterland, however, the incremental demand this places on commodity markets may continue to ease.

• Relative Wage Costs
Another point so widely discussed on this blog is that, given the level of US unemployment, there remains very little upward pressure on wages. This should prove a strong tailwind for corporate profits. In emerging markets the situation is quite the reverse, with increasingly large wage settlements used as a tool to maintain political popularity, or to suppress potential insurgents. This is a clear headwind for profits, and is particularly painful for the state-influenced companies that dominate emerging stock markets.

All this being said, the more widely-known emerging market fund managers continue to deliver impressive levels of outperformance. This is largely because they recognise the above issues and select companies with profitability in mind. Those companies and regions offering better fundamentals are, however, starting to trade at rather challenging valuations. Regardless of the manager, therefore, an improving US economy is best exploited by US equity investing.

Time to let the Old Guard do its job in these more uncertain times. Let’s just hope Warren Gatland (British & Irish Lions manager) never faces such a dilemma.

Ben Gutteridge

Divisional Director - Research

The week ahead...

Guy Foster talks to Bloomberg

This week is going to be a busy one for earnings and economic news. There are 82 European and 143 US companies reporting this week. So far this earnings season, results continue to be reasonable in terms of profits, but with disappointing revenue growth.

As far as economic data are concerned, monetary policy will be in focus. After Japan left policy unchanged last week, the Federal Reserve Open Markets Committee (FOMC) and Bank of England’s Monetary Policy Committee (MPC) are expected to do the same this week. US data have been weak recently, and this underlying trend has largely flushed out expectations that the FOMC will taper its asset purchases over the course of 2013 (the term “tapering”, meaning slowing, was introduced in the minutes of the last Fed meeting). We continue to believe the Fed will maintain the rate of asset purchases ($85bn per month) throughout this year as the impact of lower government spending starts to weigh on the US economy.

On this front, US GDP was a touch disappointing at a headline level on Friday (2.5% rather than the forecast of 3%), but the strength of the consumer spending component was reassuring. It suggested that, in the early months of 2013 at least, consumers were enjoying higher disposable incomes a result of lower fuel, food and mortgage costs. By contrast the impact of the 2% payroll tax hike which became effective at the end of 2012, and more broadly the impact of sequestration (mammoth US government spending cuts) had so far been weathered by the economy. The impact of sequestration will be more intensely felt in the second and third quarters of 2013.

The Bank of England has probably seen just enough economic resilience (UK GDP beat expectations) to preclude a further bout of quantitative easing. The dovish camp currently contains three members so a further two converts would be required to bring about a change in policy.

In the eurozone, however, a thin majority of forecasters are now expecting the ECB to lower the headline “refi” rate (the eurozone equivalent of the UK’s base interest rate) by 25 basis points. Whilst recognising that it wouldn’t achieve much in practical terms, we expect a cut on Thursday as a precursor to an unconventional monetary response at the June meeting. With a marked downturn in German economic data we believe the pressure on the ECB to act has been ramping up significantly over the coming weeks. This afternoon showed the German rate of inflation falling to 1.2%, its lowest level since September 2010

There are a lot of data from the US this week covering confidence and house prices, but the main focus will obviously be the non-farm payroll numbers on Friday. The market is looking for just 150k news jobs, below the 200k trend of the last two years, but we suspect most commentators will be looking for revisions to last month’s disappointing 88k report.

 Guy Foster

Head of Portfolio Strategy

UK GDP: (not so) Deeply Dippy

Source: ONS/Brewin Dolphin

The Office for National Statistics reported this morning that Gross Domestic Product (GDP) grew by a lacklustre 0.3%. This was ahead of the market’s expectation of just 0.1%

GDP is the generally accepted gauge of how an economy is performing. It informs us of how rich we are as a country and, by dividing GDP by population, gives the measure of GDP per capita which gives an indication of standards of living. Furthermore it reflects the size of the assets against which our national borrowing can be secured. Therefore measures such as budget deficits (net new borrowing each year), national debt (total outstanding government debt) and external debt (debt owed by government, companies and households to foreigners) are all expressed in terms of GDP. This makes sense because GDP can also be taken as a crude proxy for the activity against which the government can levy taxes.

Following on from the fourth quarter of 2012’s -0.3% dip, a further negative reading would have been classed as a recession. The line between no growth and recession is infinitesimally small from an economic perspective – particularly given the lacklustre rate of growth seen in recent years – so this distinction matters more for the media and politicians than for investors. To talk about single, double or triple dip recessions suggests some sort of equivalence between slowdowns. In fact they are of massively different magnitudes. Nevertheless avoiding the triple dip certainly feels good.

The measurement of GDP marries several components which help us to understand why growth has been so weak. Using the expenditure calculation method, GDP is the sum of consumption, investment, government spending and net trade (exports less imports).

Ordinarily government spending rises during economic slowdowns and falls as the economy recovers. This effect is largely caused by unemployment benefits and is helpful in smoothing the pace of GDP growth. The cyclical fluctuations in unemployment benefits are therefore known as ‘automatic stabilisers’ for an economy. Beyond these cyclical components, however, the political consensus is that public finances need to be reigned in, with a rabid debate ongoing about the pace of that adjustment.

Government spending, therefore, is unsurprisingly not making a huge positive contribution to the growth of GDP.

Consumption has been the most consistent provider of growth in the post-financial crisis world. It has, however, also been below the pre-financial crisis trend. Partly that’s because of the ongoing process of deleveraging, by which we mean, raising savings rates. Households have felt inclined to rebuild their home equity, having used that equity in previous years to fund consumption. The policy response has been to lower interest rates, thereby discouraging saving and encouraging borrowing.

This policy has unleashed the forces of financial repression. As we have commented before, these have seen inflation rise above rates of return available on low risk investments and above the underlying rate of wage growth. Overall, however, while the policy does discourage bank saving, it is not greatly encouraging for consumption, because it reduces spending power. Perhaps, on that basis, we are surprised to see any positive contribution from consumption over recent years.

Part of the explanation has been that the UK’s employment performance has actually been quite strong. The UK added half a million jobs in 2012 alone and so, even with financially repressive take home-pay, there is clearly going to be a positive contribution to consumption.

Lower interest rates and quantitative easing have seen the pound fall around 15% on a trade-weighted basis over recent years. The hope was that the weaker currency would see exports rebound and imports fall – providing a net trade boost to GDP. Trade, however, has been an ongoing disappointment for the UK. This is because Britain’s largest trading partner, the eurozone, has turned in an even more woeful economic performance than the authorities had projected, and now remains in something of a prolonged slump.

Here the UK now needs to re-orientate itself towards countries which have better growth prospects and there is a reasonable case for believing that these come from the emerging world. This has been one of many differentiators between the German economic success story (admittedly showing signs of faltering now) and the UK’s tale of relative woe.

Bizarrely this should not be seen as unequivocally bad news for UK equities. The financially repressive monetary policy operates by encouraging investors to flee low yielding ‘safe’ assets and invest their funds more profitably. That should mean short-term gains but long-term pain as the distorting policy is eventually removed. At the moment, however, dividend yields remain in line with historic averages suggesting no great concern over elevated valuations.

Weak economic growth, therefore, lowers bond yields and thereby discourages investors from holding their cash in anything other than shares. The question is whether the same forces reduce the potential return on shares. Here the picture is more optimistic as the eurocentric focus of UK exports is not shared by the focus of FTSE 100-listed UK company revenues. These are directed more towards resilient areas such as Asia and the US.

Guy Foster

Head of Portfolio Strategy

Valuation bears – one born every minute

Photo: Hamed Saber

Given that my partner and I are now in the final trimester expecting our second child, just as with the first, I am now being ‘encouraged’ to watch Channel 4’s weekly show, One Born Every Minute. For those who have not seen it, the show explores the birthing experience of everyday couples across the UK. To demonstrate my compassionate side, and to acknowledge my admiration of what my better half is about to go through, of course I oblige. Given we have Sky plus, missing Celebrity Pet Swap has also become less of an issue.

Without wanting to spoil the fun, the show runs to a familiar path. Initially we are presented with an adorable loving couple, whom we are immediately compelled to route for. Then, as we go deeper into the story (typical in theatre), things get a little worrying. In the end, however, we are rewarded with a thoroughly gratifying outcome as parents finally cradle their new bairn.

I highlight this because I believe (believe it or not!) the journey of watching One Born Every Minute is very similar to the current experience of investing in US equities. How is this so? Well, for some time this blog has discussed the compelling story of the US economy, paying particular attention to the ongoing recovery in the US housing market and its industrial renaissance. As we go deeper into the story, however, and in particular looking at stock market valuations, one might start getting a little concerned. In the end, however, and despite the heightened anxiety valuations may bring, we are hopeful of a rewarding outcome.

This blog will try to underline why we believe valuations, and in particular ‘cycle-adjusted’ valuations, are not quite as frightening as they may first appear, and why we remain positive on the US stock market.

For those less familiar with the various equity market valuation techniques, Price to Earnings (P/E) measures the multiple investors are paying for a year’s earnings. For example, a company with annual earnings of $1 per share, trading at $10, is considered to have a PE of 10x.

This relatively crude measure pays no consideration to the fact that earnings are heavily influenced by where we are in the economic cycle. For example, if we are in the depths of a recession we would expect prices to fall and earnings to recede. However, upon recovery we would also expect the figure to normalise (move higher). Should $1 of ‘recessionary’ earnings move to a $2 figure in normal economic conditions, a ‘normalised’ P/E ratio of 5x ($10 price divided by $2 normal earnings) might be the more appropriate rating. Such a move would also render the company not quite so optically expensive.

Conversely, if we are in the midst of a boom, prices are likely to be rising and earnings with them. As a result, one might expect authorities to undertake tightening measures and, therefore, for earnings to normalise at a lower level. Using the above example, if $1 of earnings were delivered during a ‘boom’, then more normal earnings might be 50cents per share. The P/E ratio therefore, would register at 20x rather than 10x. This adjustment would leave the company looking decidedly more expensive.

One valuation method that accounts for this volatility in earnings, and that attempts to normalise the figure, is the Cyclically Adjusted PE Ratio or CAPE Ratio. This ratio is based on the average inflation-adjusted earnings from the previous 10 years, hence why it also know as PE 10.

This method was deigned by Robert Shiller and is discussed in much greater depth in his famous book ‘Irrational Exuberance’. The CAPE Ratio for the S&P 500 going back to the late 19th century is shown below.

Source: http://www.multpl.com/shiller-pe/table

With roughly 150% total return delivered by the S&P 500 since its trough in early 2009, investors are right to question whether valuations remain supportive of a bullish view. Indeed, further analysis of the CAPE ratio may well lead you to a rather worrying conclusion – that US equities are ‘over-valued’. The CAPE ratio currently sits at around 23x, with the long term average at about 16x. According to this measure, therefore, it would take a 30% correction in US equities to bring us back to ‘fair’ value.

Why then, with this challenging valuation backdrop, do we remain positive on US equity markets? The over-arching belief is that profit margins, though cyclically high, are sustainable. The lower earnings figures delivered in the less positive phases of the current economic cycle should, therefore, be awarded less importance.

Why do we believe profit margins are sustainable? There are four major arguments supporting this view.

1. Cost of debt
The US central bank is providing increasingly transparent guidance on when interest rates may rise. 6.5% unemployment has been ear-marked as the figure likely to trigger a review, though there is no commitment to hike when this level is achieved. Current predictions are for 6.5% to be attained by early 2014 – though this date will likely be extended on the back of recent disappointments in the payroll data.

2. Wages
Given the level of unemployment still plaguing the US economy, employees are still on relatively weak grounds in wage negotiations.

3. Reduced energy costs
Again, something that has been discussed at length is the US shale gas boom and, in close pursuit, shale oil. Cheap energy costs keep manufacturing costs down, supporting profits.

4. Continued recovery in housing
The US housing recovery continues to gather steam. This raises household wealth, boosting consumer confidence and increasing their propensity to spend.

With government spending cuts now starting to bite, it could be that we are entering a period a softer US economic data. High gasoline prices are also likely to crimp consumption demand, and a stronger dollar may dampen overseas earnings performance. It could well be, therefore, that stock markets suffer a few wobbles over the summer, and investors have to take a little bit of pain. Not quite to the extent of childbirth, but uncomfortable nonetheless!

All in all, however, whilst we acknowledge the CAPE figure rightly raises a ‘yellow flag’, there are sufficient grounds to stay the course.

Ben Gutteridge

Divisional Director - Research

Barbaric times for the barbarous relic

What has been the cause of the flash crash in gold since Friday? On the face of it the three legs of the gold bug’s stool ought to be stronger than ever.     

Cyprus has provided the first concrete evidence of deposits not being safe in nominal terms though the deposit levies that were eventually restricted to two banks and deposits of over €100,000.  That surely ought to make investors seek physical stores of value like precious metals.   

The longer lasting driver of gold’s value, negative real interest rates seem set to continue. Indeed with Japan’s determination to use extraordinarily aggressive means to meet an inflation target of 2% per annum that would imply that they will be joining the negative real interest rate club too.   

This leads us on to the third leg of the gold bugs’ stool: currency debasement.  Japan has indicated it will be running the printing presses (or, less emotively, “doubling the monetary base”) for at least the next year and, in reality, probably well beyond.   

Upon closer inspection, two of these trends have seen modestly negative developments.   
The Cyprus debacle turned from gold positive to gold negative following the news that the ECB was putting Cyprus under pressure to liquidate gold reserves in order to meet sovereign debts.  Cyprus’ gold reserves are modest in the context of the overall gold market and yet the implication of new supply seems to have made a jittery market very nervous indeed.  The implications are that other gold holders might be pressured to follow the same path, most obviously Italy which has nearly 80 million ounces of gold – 8% of global central bank holdings.   
 
Furthermore the pendulum of central bank focus may well have swung towards easing in Japan but there were tentative indications that it would swing back towards tightening in the US.  This is important because it is the dollar price of gold which everyone watches like hawks.  Ironically on Monday the gold price in yen performed even worse than the gold price in dollars as the yen rallied on risk aversion – a trend which remains in place even after the Bank of Japan’s policy switch.  Over the longer term, gold in yen has remained a profitable trade fitting the negative interest rate thesis.   
Last week’s Federal Reserve Open Market Committee (FOMC) minutes discussed the possibility that the current rate of asset purchases might be tapered during 2013.  Various Fed members have discussed removing accommodation, only to be quashed by Chairman Bernanke’s promise that the Federal Reserve will continue to provide accommodation as required. The appearance of such statements in the carefully crafted minutes was sure to grab attention.   
 
We don’t see that tapering taking place. If anything the recent economic data have argued against the removal of accommodation. Housing, employment and consumer confidence data have suggested a weakening over the last month.  Were asset purchases to be tapered this would not undermine the negative real interest rates argument which remain firm.   

So why the sell off? The reality is that gold has no easily appraisable fundamental value.  Rather its value is an article of faith.  We can see what newsflow would be helpful for the gold price and we can see what would be unhelpful but when all the potential converts have been converted, there is nowhere left to go.    

Another way of putting this is using Dow theory.  This suggests that an investment idea has three distinct phases. The first phase is the accumulation phase when astute investors buy assets before they have become popular. The second phase is the public participation phase when the idea gains widespread acceptance and price gains accelerate.  The final phase is the distribution phase in which the astute investors sell to the late comers.   

Part of the bear’s case is that gold is the ultimate greater fool asset. We cannot gauge where the demand will come in because any investor buying does so only on the basis that somebody is willing to pay a higher price for the same asset at a later date but still based on the same underlying economics. Industrial metals by contrast have a floor when their necessity for economic production meets their marginal cost of production.   

The question which haunts gold investors is where does this cycle end? How will we be able to decide the point at which to sell to the greater fool?   

Now consider the recent history. We have seen strong gold newsflow for some months now:

• On 2nd August 2012 we heard Mario Draghi announce the Outright Monetary Transactions programme – wrongly assumed by many to be some form of quantitative easing but rightly assumed to open the door to potential monetisation of eurozone government debt.
• 13th September 2012 the FOMC announced it would start buying $40bn per month of Mortgage Backed Securities with printed money until further notice.
• 12th December 2012 the FOMC expanded this programme to include $45bn of treasuries.
• Added to which we had the promise – eventually met – of more stimulus to come in Japan too.

  
For gold to have laboured during such a period of bullish newsflow we have to assume it has lost some of its lustre.  So could this be the end of the bull market? The question now is whether the fundamental support will return.     

Physical buyers (like Indian jewellery demand) will wish to take advantage of new lower prices but tend to do so only once stability has returned.  Algorithmic trend-following hedge funds are likely to buy only once an uptrend is established. Central banks may be buyers in the physical market, however, their motivation is diminished by a reduced pace of foreign exchange reserve accumulation and the potential for gold assets to be seen as a potential fiscal funding source (this last point is unlikely, but possible).

We spoke to an investor from a very large asset management firm this morning who was buying following the fall – that is important as it is that type of investor who needs to restore order to the gold price and the negative view recorded in these notes will not change until stability has been found. 

I asked how he values his holding. The answer was an acceptance that you can’t.  He made the distinction between the journey and the starting point.  Negative real interest rates tell him he’s walking in the right direction but the sentiment-driven nature of gold means he doesn’t know whether he started in the right place.  That makes sense but the risk is clear.

Guy Foster

Head of Portfolio Strategy