Market Review 3 August 2010

To our minds, the second quarter was something of an aberration in what should otherwise be a continuing equity bull market. The reason for the sharp change in direction in April and May was, of course, a major financial crisis made worse by the European authorities’ initially slow and muddled response. However, from mid May onwards, the official response became more decisive and from the first week of July, we saw the appetite of major European institutions for risk recover. That recovery has been helped by an exceptionally good earnings reporting season and the first clear indications that major commercial banks are now able to write-back loan provisions that they had taken earlier.

The most awkward feature of the last year has been the sluggishness and, in certain instances, the contraction of the growth of bank credit. There are three possible explanations for this: renewed fears about asset quality, slower prospective growth and regulatory incompetence.

It is clear that the second quarter’s Greek sovereign debt crisis raised the spectre of impairment of another swathe of bank assets. It is also clear that growth prospects in North America have slowed, although probably not sufficiently to induce a “double-dip” and, intriguingly, this growth slow-down may be being offset by a growth pick-up in Europe. However, the insistence by governments that banks raise additional capital swiftly has been a major issue.  Fortunately the implementation of the proposed new Basle III rules has been delayed.

In our view, the central constraint on economic recover in the leading economies since mid-2009 has been official pressure on banks to raise their capital/asset ratios. Also relevant – but to a lesser degree – have been the calls for higher ratios of liquid assets to total assets. Both the higher capital/asset and liquid asset/total asset ratio are part of the Basle III package of banking rules. Almost certainly, this pressure for higher capital/asset ratios has been associated with virtual stagnation of the quantity of money (on broadly -defined measures) in the US, the Eurozone, the UK and Japan for about 18 months. Because the growth of money and nominal GDP are related, the economic recovery has been disappointingly feeble. In most countries unemployment remains close to its peaks. Indeed, in the Eurozone unemployment is still rising.

However, at its latest meeting the Basle Committee of Banking Supervision agreed to ease its definition of bank capital and, more important, to extend the transition period in which higher capital/asset ratios would have to take effect. Reports vary, but the deadline now appears to be 2018 (or even 10 years from the finalisation of an accord) instead of the end of 2012.

This deadline extension is hugely important for the likely path of the growth rate of bank balance sheets – and hence the quantity of money – over the next few years. Early talk was of a doubling of capital/asset ratios. If banks had had to do that in two years with unchanged capital, they would have had to shrink their assets by 25% – 30% in each year. But with an implementation deadline of 10 years, the annual rate of asset shrinkage on unchanged capital assumptions drops to only 7%. Indeed, since banks can, in practice, both raise capital by way of bond and equity issues and via the usual build up of capital from retentions, they should be able to avoid asset shrinkage and, indeed, add to their loan assets as well.

Strict monetarists would make the point that the regulatory attack on the banks to raise new capital hastily has been the main cause of the monetary stagnation over the last 18 months, and, therefore, of the patchiness and unconvincing nature of the economic recovery. By giving banks longer to sort themselves out, the prospect is now emerging of a positive, albeit low rate of growth of broad money from here on, particularly in the UK. Zero interest rates on money balances have probably reduced people’s desired ratio of money to expenditure and wealth – money growth of only 3% -5%, therefore, could be consistent in 2011-14 with nominal GDP growth of 5% -7% and hence with quite a brisk recovery in due course.

We have been comforted in recent days by the growing extent to which banks are now writing back loan loss provisions and the recovery in banking profitability.  HSBC’s first-half net income has doubled as their North American unit returned to profit for the first time in three years and as bad-debt provisions fell by 46 percent. Pretax profit of $11.1 billion beat the $8.8 median estimate of 10 analysts surveyed by Bloomberg. Similarly, BNP Paribas’ second- quarter profit rose 31 percent as bad-loan provisions dropped to the lowest level since before Lehman’s bankruptcy. Net income rose to €2.11 billion topping the €1.61 billion median estimate of eight analysts surveyed by Bloomberg. This quarter, for the first time since the second quarter 2007, provision write-backs exceeded new provisions, and the loan book saw no new significant doubtful loans.

It still appears, though, as if US growth is slowing. The US second quarter GDP statistics published last Friday were riddled with revisions, which had the advantage of making rather more sense of the path of the recession over the last 3 years. Nonetheless, a picture emerges of a deeper recession and a slower recovery. We are now invited to believe that the US economy grew at a 2.4 percent annual rate from April through June, following a 3.7 percent pace of expansion in the first quarter, which had been previously reported as a 2.7 percent gain.

Meanwhile a large amount of back data was revised. As a result, we now have a better explanation of why the US jobless rate doubled, reaching a 26-year high of 10.1 percent in October, and why it has been slow to subside. Personal income levels in each of the past three years have risen but the savings rate is higher – all of which suggests that households are further along the process of repairing their finances.

The rebound from the recession has been more subdued than originally thought.  In the last six months of 2009, the US economy grew at an average 3.3 annual pace from July 2009 through December, instead of the 3.9 percent previously projected.  The worst quarter of the economic slump is now reckoned to be the final three months of 2008, in the immediate aftermath of the collapse of Lehman, rather than the first quarter of 2009. US GDP shrank at a 6.8 percent pace from October to December 2008, higher than the previous estimate of 5.4 percent, making it the deepest quarterly drop since 1980.

The new data suggests that the peak of the last expansion occurred in the fourth quarter of 2007 rather than the second quarter of 2008 and this chimes better with the recession chronology prescribed by the National Bureau of Economic Research.

The US Federal Reserve’s Beige Book, published earlier last week, confirmed the US Federal Reserve’s overall assessment that economic activity going forward was likely to be weak. US manufacturing appears to be on a plateau after the restocking of recent quarters.  Consumer spending is still in positive territory but with a clear emphasis on non-discretionary items. Demand for autos and other big ticket items is sluggish. There was no surprise in the weakness or the profile of commercial and residential real estate. The modest improvement in labour demand fits with other earlier labour market statistics. This Beige Book in fact, served to summarize much that was already known emphasising that there is little prospect of any removal of the Fed’s accommodative monetary policy settings before the second half of 2011.

Meanwhile, there is no problem with corporate earnings – at least there has not been in the second quarter. Second quarter results thus far have surpassed forecast. Nearly 70% of S&P 500 stocks by market capitalisation have reported, and the second quarter is shaping up to be one of the best quarters on record both in terms of the breadth and magnitude of upside surprises. At an estimated $20.90, blended headline earnings per share for the S&P500 is almost 8% higher than at the beginning of the earnings season three weeks ago.

Margins have seen remarkable gains. S&P 500 margins (ex financials and utilities) are 50 bps above their initial bottom-up consensus estimate before the reporting season began. It is clear, now that we are about two-thirds of the way through the current reporting season, that US corporate profitability has staged another remarkable improvement. Analysts are having to revise up their profit estimates for this year. Brown Brothers Harriman, for example have raised their second quarter estimate to $21.25 from $20.40 and their full year estimate to $82.75 from $80.00.

Generally though, analysts have been unwilling to raise estimates for 2011 in expectation of slower growth next year. We suspect that this is just natural conservatism. In fact, the most encouraging feature of the US GDP figures was the remarkable strength in business spending. US companies’ investment in structures appears to be stabilising while their outlays on equipment and software maintained their strong first-quarter pace of growth. While anecdotal reports suggest that business spending is largely a reflection of the need to replace worn-out equipment and garner cost-savings and that very little expenditure relates to expected increases in demand. There is no reason why such growth should not have continued in the current quarter.

Meanwhile, the valuation of equities looking forward has fallen sharply since mid-April. US equities were valued at 13.6 times then and are now valued at 12.3 times. UK earnings were valued at 11.5 times and are now valued at 10 times, Europe ex the UK at 14.5 times and are now at 13.1 times.

In Europe, confidence is improving. Eurozone business confidence indicators continue to come in firmer than expected.  The European Commission’s confidence measure rose from -6 to -4. The move was reflected in all subcomponents, with orders increasing from -26 to -21 and employment improving from -9 to -6. Consumer and service confidence indicators were also stronger, with a notable increase in recent demand for services from 4 to 8. Italian business confidence also beat expectations rising to 98.3 from 96.3. The improvement is generally in line with recent data, and in particular with the strong German Ifo survey reading, and is keeping the Euro supported. Sweden consumer confidence rose to its highest level since October 2000 in July while Q2 manufacturing confidence improved from -4 to -3.

As the financial crisis in Europe recedes and as European growth appears to be stronger than in the US, both Sterling and the Euro have been strengthened. Indeed, the strength of the Euro and Sterling have been two notable features of July.  Over the month, the Euro has risen by 6.65% against the US Dollar and Sterling has risen to 4.9%. In the case of our Euro and Sterling portfolios we remain fully hedged back into the Euro and Sterling and we have generally increased our exposures to these currencies in the US dollar denominated portfolios.

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.