The week began well but faded badly. There was a 90% up-day in the US on Tuesday but a 90% down-day on Friday. The US earnings reporting season began with notable results from Intel after hours on Tuesday and JP Morgan on Thursday. These results confirm two things, namely that capital investment spending is, indeed, accelerating and associated with that fears of a peaking in the semi-conductor cycle are premature.
The more general concern remains about the likely progress of monetary policy. On Friday, 2-year US Treasury yields dropped to new lows – lower even than at the time of the Lehman Brothers collapse. Meanwhile German 2-year yields rose above US dollar yields and the euro strengthened significantly. Monetary policy is critical. If central banks fail to inject sufficient reserves to encourage commercial banks to lend more, it would be a dampener on activity.
On Friday, there was a sense that outright deflation could be in the offing. Bank balance sheets at the moment are improving but loan growth is now in negative territory. The JP Morgan results suggested that the underlying quality of consumer credit in the US is improving especially in the areas of credit cards, mortgages etc although it is not growing. Elsewhere, a notable development was the ability of the Spanish government to complete a 15-year bond auction in the market place. The government had to pay more than previously but the issue was more than fully subscribed.
The softer trend of developed world economic data continued with poorer Empire Manufacturing data and weaker manufacturing figures from the Philadelphia Federal Reserve. By way of contrast, some of the Asian statistics were good. Notably, this was true in Singapore, which had an 18% increase in GDP in the second quarter. In general, there has been a relatively high level of correlation between stocks – which does not make life easy for stock pickers and a sign that a lot of the action is being driven by buyers or sellers of index futures.
Despite the difficulties of recent weeks, the attraction of equities is gently improving. Valuations are historically low relative to other asset classes, particularly when companies themselves are significantly outperforming the global economy. Investors are starting from a low equity exposure level after a protracted period of low returns. The unattractiveness of risk free assets as a longer-term alternative has, if anything, only got more compelling as the year has progressed. Short-term cash has seen considerable volatility from currency moves while longer-term sovereign debt has re-priced upwards despite concerns revolving around the credibility for repayment of this debt.
Fears that growth will be anaemic for a protracted period are probably overstated. Demand in developed nations is sufficiently below replacement levels to make it difficult to see it falling much further. In the US, home-building is c. 1/3 of household formation, auto purchases c. 70% of scrappage and aeroplane orders as little as 20% of natural retirements. Meanwhile, developing nations’ shift towards a more consumption-led model now seems well established. It is worth noting that nominal GDP this year in the BRIC countries is expected to touch nearly 15%.
For the fifth time in a row, Intel kicked off the US earnings reporting season by delivering a fifth beat of analysts’ estimates. Second quarter revenues came in at US$10.77 billion which was substantially higher than analysts’ estimates at US$10.25 billion. Margins were higher and the mix of products sold better. The company provided positive guidance for the September quarter, which was good because the market had been fearing the peaking of the semi conductor cycle. What is, in fact, clear is that corporate PC demand is strong, strengthened further as the second quarter progressed and that rising corporate profits is stimulating corporate spending on IT.
In the case of JP Morgan, the earnings per share for the quarter were $1.09 per share, compared with an estimate of $0.70. Investment bank revenues were a bit light. The overall asset total contracted with loans down 8% in the quarter. However, all and more of this, was offset by the release of reserves. The rate of home equity losses per share during the quarter dropped from $1.4 billion to $1 billion and there was a $1.5 billion reserve release versus an estimate of $426 million in the area of credit cards and i-banking. Tier 1 capital rose to 9.6% versus 9.1%. There was no increase in dividend but $500 million was set aside to buy stock in the market.
In recent days we have been adding high quality US, German and British longer dated bonds to our balanced portfolios. As much as anything, it is designed to dampen volatility in the overall portfolio and to acknowledge deflationary risks that are implicit if bank lending fails to revive. We have also increased our non US dollar exposure for dollar accounts and hedged the bulk of our dollar exposure in sterling and euro accounts back into euros or sterling, as appropriate.
Andrew Dalton is Chief Investment Officer of the Dalton Strategic Partnership, an investment management boutique in London which he founded in 2003 after 30 years as a senior investment professional at S.G.Warburg, Mercury Asset Management and Merrill Lynch Investment Managers.