Market Watch - July 2008

The UK equity market fell sharply in June, with the FTSE All Share index declining by 7.4% over the month. The large-cap FTSE 100 index fell by 7.1%, while stocks lower down the market-cap scale fared even worse, with the FTSE 250 and the FTSE Small-Cap indices falling by 9.0% and 8.8%, respectively. From a sector perspective domestic cyclicals took another battering with banks, retailers and real estate all posting double digit falls. All sectors were negative but defensives such as healthcare and utilities held up best as well as oil and gas boosted by the spiralling oil price.
The heavy falls were a result of a list of issues that have threatened the UK economic wellbeing, which seem to be coming from every quarter. Triggered by the credit crisis, other concerns that are being talked about daily include inflation pressures, rising interest rates, rising fuel and food prices, property market slumps, and the weakening consumer.

As widely expected, the Bank of England’s Monetary Policy Committee (MPC) kept interest rates on hold at 5.0% over June (and again in July). Although price pressures continue to gain momentum, the mounting evidence of an imminent economic slowdown is more concerning. In terms of the housing market, data continued to point to further falls

So pretty gloomy stuff! And no-one doubts that the domestic economy will remain under pressure from consumer debt and falling house prices for some time.  However we are not predicting Armageddon for the UK Stockmarket, a negative scenario is already priced in to many areas of the equity market and many cyclical sectors are already showing the 30 -50% falls associated with a recession. Also, on a corporate level strong balance sheets continue to provide support and from a contrarian perspective we like the fact that there is excessive fear in the market. 

Over the summer, markets are likely to be dominated by economic data which is likely to remain negative and result in high volatility. Whilst very negative sentiment could drive the market down further in the short-term we believe market downside will be limited given investor cash levels, attractive valuations, the low level of bond yields and a slow decline in commodity prices. We are not traders, we are investors and believe that the coming months will represent a good time to invest in many areas of the UK equity market for long-term investor – we are particularly focusing on valuation and not momentum. We will be looking at investing in areas that are oversold and which may feel uncomfortable for those focusing on the short-term. Equity income will remain a favoured theme and we are confident on the recovery potential for UK equities and believe that when investors begin to focus on valuations once again, the market has potential to rally.

US stockmarkets fell heavily over June, as oil prices climbed relentlessly higher. The Dow Jones Industrial Average fell by 10.2%, whilst the wider S&P 500 index fell by 8.6%, its worst monthly fall since September 2002. The tech dominated Nasdaq and Russell 2000 small cap index fell by 9.1% and 7.8% respectively.

Oil was the only sector to make gains as analysts revised forecasts based on the soaring price. Political concerns in the Middle East offset news of an increasing inventory and falling domestic demand. At the other end of the performance tables, financial fell heavily with many leading institutions being downgraded by Standard & Poor's.

In economic news, the US Federal Reserve (Fed) held the headline US interest rate at 2.0% as expected, but the tone of the accompanying message led investors to think the Fed was leaning away from a near-term rate rise, which weakened the dollar.

The recent tax rebates helped to boost consumer spending, with positive retail sales figures. US manufacturing is holding up well, aided by continuing export strength. However, there was plenty of negative news too: the consumer confidence index slumped to its lowest level in 16 years, the trade deficit widened, house prices fell at a steeper rate, mortgage delinquencies climbed and headline CPI inflation hit 4.2% in May.

Going forward, we believe that the US stockmarket has potential to regain leadership amongst equity markets. The threat of recession and the slow housing market will weigh down on domestically focused sectors in the short-term, but as we move through 2008 and into 2009, many believe it will be the US that leads the developed world out of the current slowdown.
We believe a portfolio focused towards global leading multi-nationals should perform well, many of which can be bought more cheaply than at almost any time in the last twenty years.
Exporters are thriving; indeed exports from the US to China are now growing far more rapidly than trade in the other direction.

European equity markets were hit hard and the FTSE Europe ex-UK index fell by 11.2% (€) while the HSBC European Smaller Companies ex-UK declined by 10.4%. On a sector basis, healthcare and basic materials proved most resilient, suffering only modest falls, while more severe declines were evident within financials, technology, industrials and consumer related sectors.

Like other Western markets, falls were precipitated by heightened inflationary worries, driven by commodity prices, and a worsening macroeconomic picture saw markets fall to their lowest level this year. Investor sentiment has remained fragile and weak corporate news-flow offered little support to equity markets.

The economic backdrop saw inflation within the eurozone surge to 4%, a 16 year high. As such, ECB officials have signalled that an interest rate rise of 25 basis points (bps) will happen at the next meeting. Consumer confidence continues to fall and business surveys are just as bad. Although the strength of the labour market within Europe has been one of the most encouraging indicators over the past few months, high profile corporates have been signalling job cuts with companies across Europe looking to reduce costs.

As predicted the past quarter has seen European stockmarkets have a difficult time. Going forward the strong euro may damage exporters’ prospects and we are cautious on the prospects for the domestic European economy. As stated inflationary pressures are effectively curbing any potential interest rate cuts which are needed to stimulate growth as the global economy slows down. It may be a good time to reduce exposure and take a defensive position in Europe after a sustained period of strong performance.

Japanese equities followed global stockmarkets lower as global inflation concerns weighed heavily on investor sentiment. The Nikkei 225 index was unable to avoid the sharp falls elsewhere in the world, with the index recording its first fall in three months. The Nikkei 225 was down by 6% over the month, while the broad-based Topix index fell by 6.3%. The reduction in risk appetite negatively impacted the small-cap area and the TSE Mothers index, which also measures new high-growth companies, fell heavily by 17.2% during the course of the month.

In line with the global trend, on a sector basis, the defensive areas of the market outperformed.  Utilities, agriculture and transport were the best-performing sectors, actually producing positive returns during June. Unsurprisingly, financials were among the worst-performing areas. Other finance, real estate, securities and the banking sector all suffered double-digit falls.

On the macroeconomic front, Japan still appears to be staving off a recession in spite of the impact of high oil and commodity prices. Data for May presented a picture of solid industrial production, relatively high headline inflation and a reasonably stable jobs market. Nationwide CPI inflation rose 1.3% year-on-year. On a negative note, household spending deteriorated further in May and Japanese business sentiment also signalled a further loss in confidence.

Overall, we are positive on Japan. The macro backdrop looks relatively benign compared to other developed economies, and Japan could actually benefit from rising inflation. It seems that the market has already priced in a very negative economic scenario and the resilience in  Japanese equity markets over the past quarter is encouraging as it is illustrating that the market maybe starting to capture the interest of investors. We have met several Japanese fund managers recently who have turned very bullish upon their own market and believe it is close to its trough and well positioned for recovery. Valuations are at their most attractive levels in decades and cheap relative to many major international markets. If the swing in sentiment witnessed in April can be maintained then rewards from this market could be compelling.

Asian markets fell sharply in June on the back of rising energy prices and fears of more corporate write-downs. The higher beta markets of China and India led the declines this month, falling 20% (Shanghai Composite) and 18% respectively and a number of other markets also recorded double-digit falls. In fact, only Indonesia managed to limit severe falls, closing this month only 3.9% lower.

Both Hong Kong and Chinese stocks suffered as sentiment increasingly turned negative on fears about slower profits growth and high inflation. Elsewhere, India’s stockmarkets fell as inflation jumped sharply to a 13-year high. On a sector basis, commodity-related areas continued to outperform. Utility stocks also held up reasonably well, but consumer-related stocks remained in the doldrums.

On the macroeconomic front, With Asia being a net consumer rather than a producer of energy, the continued rise in oil prices has proved particularly negative. Inflation rates increasing have seen Central Banks across the region respond by tightening monetary conditions. Record oil prices have forced countries like Indonesia, India and Malaysia to reduce their fuel subsidies, which has had a sharp effect on recent inflation rates.

In Emerging markets generally, the increased inflationary pressures, accentuated by higher oil prices, dampened appetite for global emerging equities during June and the MSCI Emerging Markets (US$) index fell by 10.2%. As discussed, Asia had a particularly tough time though losses in the EMEA and Latin American regions were less severe, partly due to their status as net exporters of commodities.

Accelerating inflation and higher interest rates provided the common thread in the emerging markets. Russia’s annualised inflation rate rose to 15.1% in May, but, its Central Bank is showing its commitment to stabilising inflation. Concerns that the inflation rate could threaten Russia’s economic growth were diluted somewhat by the release of GDP data, which showed that the economy grew by an annualised rate of 8.5% in the first quarter.

Overall we remain cautious for the short-term prospects for the Far East region and many emerging markets. Inflation continues to remain a concern for central banks in the region as inflationary pressures linger and it remains to be seen how the slowdown in the West will affect these economies. However, we are more comfortable with valuations in many areas following significant corrections in recent months. It is impossible to ignore the fact that the economic growth in Far East and emerging markets continues to remain far superior to developed markets and we expect currency strengthening in these areas should boost returns for sterling investors.

Therefore, we believe that exposure to defensively managed funds in the Far East provide good potential and being selective is key to emerging market investing, with Russia and Africa amongst our current favoured areas for more speculative investors.

Over June, bond markets showed a reversal in recent trends, as inflation and slowing growth combined to hurt most areas, and inflation hedging index linked gilts were one of the few areas to provide a positive return.

Most fixed interest sectors fell over the month in capital terms. High Yield was the hardest hit as risk aversion increased with the IMA UK Other Bond sector falling by 2.4% over the month. This was followed by the IMA UK Corporate Bond and IMA Global Bond sector, which produced negative capital returns of 1.3% and 1.0% respectively. Government bonds proved more resilient with the IMA UK Gilt sector showing a fall, in capital terms, of 0.95%.

The falls over last month saw credit markets give back their recent gains as concerns resurfaced surrounding the short-term outlook. Although Government bond markets saw some support as equity markets also sold off, both UK and European yields increased as inflationary pressures dominated in the headlines, and US Government bonds remained flat. Spreads between corporate and government bonds widened and June saw global high-yield bonds post a 2.9% loss, while European high-yield bonds posted a 4.9% fall.

Going forwards, our view remains that corporate bond markets have been oversold and as detailed previously, having spoken to several leading bond fund managers recently we have moved our stance to overweight. We believe that the general widening of spreads between the yields on government and corporate debt make investment grade bond yields look attractive again. Also, high yield bonds are already pricing in a scenario of high defaults, consistent with a recession and many high yield bond funds are now offering double digit yields. For medium to long-term investors we believe that high yield bond funds have potential to provide some compelling returns. Based on current valuations we believe that bonds are a key component in a balanced investment portfolio.

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Our views on UK property remain unchanged and we remain very underweight as there are still several headwinds facing the sector.

Currently, demand for property is patchy and likely to remain so for some time yet, particularly given evidence that 2008 will be a challenging year for the UK economy, which will temper investors’ expectations for rental growth. It is widely expected that the balance of supply and demand for investment property will lead to further falls in capital value for the remainder of 2008, and City offices and retail outlets in particular look exposed to the current economic slowdown. However, the valuation of property relative to other assets has already improved and the yield margin over gilts is currently close to its long-run average

Property has reverted to its traditional income-driven behaviour as a sustained period of yield-driven capital growth has ended. Indeed a leading property fund manager has predicted that in the coming year, UK commercial property will not provide a gain including yield. Although the area is reaching fair value, in the very near term, momentum may well cause the market to overshoot on the downside – as often happens in a correction. Should this happen, however, we would expect long-term investors to be rewarded with above trend returns in subsequent years while the market rebalances. Looking further ahead, capital prices should show signs of stabilising in 2009, supported by an increasing demand for UK commercial property from overseas investors.

One positive for UK Property funds is that we believe that those holding a proportion in UK equities may benefit from the real estate shares sector, which is looking oversold and as sentiment improves property shares will lead any recovery. Even though we have moved underweight in UK commercial property there are still opportunities to maintain in overseas markets and believe that the diversification benefits that property exposure provides will be best achieved through using international property funds for 2008. Overseas, we favour Far East and Japan and are more cautious on US and Europe.