Normality Returns – Up To A Point

Pinch yourself for a moment and it is possible to convince oneself that the financial markets have returned to normality after the drama of the global financial crisis. Libor, for example, has returned to more traditional levels after last year’s market seizure. Many stock markets are back to somewhere around fair value. The dollar has fallen back to a point where it is trading at around purchasing power parity against sterling and the euro.

Bond yields are rising towards a level that once more incorporates at least some expectation of future inflation. The yield curve is upward sloping. Investment bankers are doing well again, even if it is largely by dint of the fees from organising rescue rights issues for each other. After a year in which it has yo-yoed crazily, from a peak of $145 per barrel down to little over $40 a barrel, the oil price has returned to a level that once more appears to bear some relationship with the fundamental balance of supply and demand. Other commodities are following suit.

But these are still far from normal times, as even the most cursory glance at the news testifies. Although the banking system appears now to have been saved by the concerted efforts of governments and central bankers, the global economy is still going backwards, only at a slower rate than before.

Unemployment continues to rise, and the fallout from the ongoing economic slowdown is causing political turmoil in some of the worst affected countries. The risk of future banking setbacks remains acute as lending losses across a range of sectors, including corporate banking, private equity and commercial property, have still to be realised.

In commercial property, for example, the bill for excessive lending threatens to be impressively large, though it has yet to show up meaningfully in reported accounts. Chris Turner, the long-serving manager of the TR Property Trust, estimated last week that the value of UK commercial property assets has fallen by around 40% from its peak of £800 billion in 2007, and there is probably a further decline in values of 10%-15% to go before the cycle is through.

The debt that supports these £400 billion of UK assets amounts to £300 billion. It is going to take several years for the property business as a whole to work its way back to a healthy capital structure – “a long drawn out and hard refinancing road lasting perhaps five to seven years”, in Mr Turner’s words.

While the recovery in equity markets has been impressive, its resilience also remains suspect. The lopsided nature of the market’s recovery, led as it has been by the most cyclical stocks, many with poor financial characteristics, appears to owe more to kneejerk reactions than to considerations of fundamental value.

Many investors have been caught out by the speed and extent of the recovery from the lows of early March and to avoid being left behind have been buying the highest beta instruments they can find. News that the Coppock Indicator has flashed a buy signal may further excite this trend.

The comments made last week on this subject by Neil Woodford, Invesco Perpetual’s income fund manager, seemed to me to be apt. He sees parallels between today’s market conditions and the two-tier market that prevailed in the immediate aftermath of the 2000 technology bubble, when many high quality companies with solid earnings and healthy balance sheets were priced on yields and p/e ratios which, both then and in retrospect, appear ridiculous, especially when compared to those accorded to much flakier businesses.

“We’re in a similar sort of polarised market” today, Woodford thinks, the irony being that the companies that are best equipped to survive the choppy economic times that lie ahead are the very ones that the market currently refuses to favour.

The cyclical stocks that have done so well in the last three months have risen to astonishing levels, in his view, given that “there’s been no recovery in the economy, there’s been no increase in earnings, [and] there’s been no tangible sign of any improvement in profitability for many months now”. As it will be a long time before the economy begins to experience a sustained renewal of economic growth, he is surely right that it leaves a lot of risk in cyclical sectors, impressive though the current momentum behind that move has been.

Of course some will say that Mr Woodford is only talking his book, as his preference for defensive, higher quality stocks has for now left his funds’ performance trailing that of many of his peers. But that would be a dangerously short-sighted conclusion. The arguments for thinking that equities are now the asset class of choice for the medium term are strong.

One historic trend that has not yet returned to normal is the yield gap between equities and government bonds, which still clearly favours the former. As was noted here last week, making money out of Government bonds over the medium term at today’s yields looks extraordinarily difficult, although there will be opportunities to trade the market’s volatile perceptions of the inflation/deflation outlook. But the value is not necessarily where the market currently chooses to think it is.

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