Market Review 5 October 2010

From an investment point of view, 2010 has been an interesting year so far.  The first quarter was a strong one for equities, the second, though, was weak, as investor fears of a banking collapse in Europe surfaced.  The third quarter has been strong.  Equity markets spent much of July and August consolidating after their falls in late April and May but then lifted their skirts in September to produce a spectacular, if slightly unexpectedly, positive result for the quarter.  Our global active funds returned 8.95% in sterling for the quarter.  Their lower risk, balanced brethren returned 6.11%.

There is now one quarter left to go.  Traditionally, the fourth quarter of the year is a period of significant seasonal strength for equity markets, though often preceded by a wobble in October.

The central tenets of our investment view have been that a cyclical economic recovery is under way, although unusually, this is likely to be an investment led rather than consumer led recovery.  We expect the recovery to be highly profitable both for corporations, which cut their costs radically in 2008, and for banks, helped by very wide interest rate spreads.

For two years, western monetary authorities have set extraordinarily low interest rates, cutting the return on holding risk free assets to the barest minimum.  This low interest rate environment stands as the clearest signpost to investors that they should be taking risk rather than holding cash.

We also believe that this recovery is unlikely to be troubled by the prospect of rising inflation.  Indeed, the risk, rather, is of deflation.  That risk is perhaps most apparent in Japan but in most developed markets any excessive growth in economic activity will be hindered by the ongoing need to repair bank balance sheets.  This thought, together with the continuing stagnation of housing markets and the urge to restrain government spending, are all factors suggesting that inflation is unlikely to be a problem over the current investible horizon.

All Western governments have a political dilemma.  They face high unemployment and need politically to do something about it.  The fiscal policy tools that remain in the authorities’ hands are limited and our sense, therefore, is that we will see another round of monetary easing in the fourth quarter.  Monetary easing can be generated either externally or internally.

External easing implies currency devaluation.  Such a move is unlikely to be a co-ordinated one, because too many countries would like to pursue this route.  In the face of this, investors are faced with the dilemma of where to store value.  The best stores of values are, of course, real assets – equities, possibly the euro or Swiss franc, which are arguably the least likely candidates for a covert devaluation, and for true believers, gold, silver and natural resources.

For US dollar based investors, it makes sense to hold equities and to have a significant degree of non US dollar currency exposure.  For European investors, whose natural currency is the euro or Swiss Franc, the challenge is greater.   Our current position for such clients is to hedge their international assets back into the euro or Swiss franc.  The outlook for sterling is more ambivalent and for sterling based accounts, we are happy to be exposed to the euro too but have largely removed any US dollar exposure.  In September, our euro denominated global active funds returned 7.05% and their ‘balanced’ peers 4.33% in euros.

We now know that the US recession ended in June 2009.  The Business Cycle Dating Committee of the NBER in the US declared this to be the case a week ago.  It has taken 15 months for this august body to reach its conclusion.  In the 33 cycles that the BCDC has identified since 1854, the average period between a US economic trough and its subsequent peak has been 42 months.  Double dips are very rare.  The last was probably in 1980.  Recent expansions, of course, have been much longer than the average.  From the trough in 1982 to the peak in 1990, the expansion lasted 92 months.  Between the trough in 1991 and the peak in 2001, the expansion lasted 120 months.  Even the 73 month expansion between 2001 and 2007 was longer than the historical average.

What is clear is that the current expansion has seen a sharp uplift in corporate profitability.  The earnings of US companies in the second quarter significantly exceeded expectations.  As we go into the third quarter earnings reporting season in the US, analysts expect 18% profit growth year-on-year for non financial US corporations and a 55% gain for financial corporations.  In the down turn, companies acted rapidly and swiftly to cut costs.  As a result, margins improved and there are signs now of a capital investment spending boom beginning.  The best indicator of this rising tide of capital expenditure is the data for US durable goods orders.  In August, US durable goods orders fell 1.3% on the back of a 54.5% decline in civilian aircraft orders, the most volatile sub component of the report.    However, excluding transportation, orders rose 2.0% and, as importantly, core durable orders increased 4.1% after a nearly 2% upward revision to the previous month. 

In terms of sector, it has been the technology and other growth segments of equity markets that led the way higher in September.  Investors are clearly differentiating between those companies with powerful long-term growth prospects, such as the ‘cloud computing’ beneficiaries but are less enamoured by legacy companies such as Microsoft, which, although attractively valued, are less well positioned for the shifts taking place.  Technological change is driving the rise in corporate capex.  Fortunately, our MST North American fund is well placed to take advantage of this and unsurprisingly had a storming September – up 12.28% versus the S&P 500 index up 7.49% in US dollars.

Even in Japan, the Bank of Japan’s third quarter Tankan survey of business conditions, which emerged at the end of September, showed a significant improvement in the assessment of business conditions for both manufacturing and non manufacturing businesses of all scales.  Large scale manufacturing rose to +8 from +1 (zero is neutral) and large scale non manufacturing rose to +2 from -5 – the sixth quarterly improvement in a row.  The large manufacturing survey has improved for the last six quarters in a row also.  Both the small firm diffusion indexes have improved for the last five quarters.

Japan, of course, is the great example of what the rest of the world wants to avoid.  Wage deflation in Japan is entrenched, the fiscal position of the government is extraordinarily poor and the central bank is timid.  According to the Japanese National Tax Agency’s Summary of Taxation, private corporate wage incomes in 2009 fell 5.5%.  That was the biggest wage cut in a history going back to 1949, topping the 1.7% decline in 2008.  Wages themselves have now fallen back to near 1989 levels.  Interestingly, the survey covered 45.06 million workers, 1.8% less than in 2008.  It is hardly surprising that domestic demand is slow and that growth is dependent on the export sector, which, of course, is hindered by a high exchange rate.

The core of the Japanese problem is a chronic fiscal deficit combined with an incoherent monetary policy.  Japan has income tax rates equivalent to those in the United Kingdom but collects half the amount of tax.  Japan collects tax from employees in large corporations perfectly efficiently but is apparently unable to collect income tax efficiently in the rest of the private economy.  The result is a massive recurring budget deficit, covered by borrowing.  So big has borrowing been that even at low interest rates, Japanese debt service now accounts for around a third of government expenditure and is equivalent to 55% of government revenues.  Meanwhile, the Bank of Japan, despite having had what has amounted to a zero interest rate policy since 1999, has been unwilling to adopt an inflation targeted monetary policy. 

As far back as December 1999, Mr Bernanke wrote an article entitled “Japanese monetary policy:  a case of self induced paralysis?”  Mr Bernanke’s recommendation, at the time, was that the Bank of Japan should shift Japanese monetary policy into a formal inflation targeted framework.  Indeed, he suggested an inflation target of, say, 3% to 4% to be maintained for a number of years.  Only by doing so, he asserted, would the Bank of Japan confirm that it was intent on moving safely away from a deflation regime. 

If that was true in 1999, it is even truer today after 8 years of zero or negative inflation. Mr Bernanke made the point in his paper that the Bank of Japan should attempt to achieve its objectives via a substantial depreciation of the yen “ideally through large open market sales of the yen”.  He asked the question rhetorically as to whether “a determined Bank of Japan would be able to depreciate the yen” and insisted by way of answer that he was not “aware of any previous historical episode, including the periods of very low interest rates in the 1930s, in which a central bank has been unable to stabilise its currency”. 

The Bernanke article is fascinating as much as anything because of what it reveals of Mr Bernanke’s mind and the light it sheds on the likely development of US monetary policy.

There is debate under way in Washington as to the next move for US monetary policy.  The Bernanke view is clear.  He remains concerned about the risks of deflation.  In effect, the FOMC lowered its pain threshold for further stimulus at its last meeting. Mr Bernanke, of course, has to carry his policy committee with him before making another major shift in the direction of additional quantitative easing.  This will probably entail some more vigorous internal debate.  There is a similar debate in the UK.  The Bank of England’s Monetary Policy Committee is due to meet on 6/7 October to assess the state of the UK economy and to decide what, if any, changes should be made to monetary policy. 

At its September meeting, the committee split 8-1 in favour of leaving Bank Rate unchanged at 0.50% with Dr Sentence pressing for, as at the previous three meetings, a 25bps increase in the rate.  Meanwhile, his colleague, Dr Posen has recently insisted that the Bank of England should restart its asset purchase programme forthwith to prevent persistent slow economic growth.  “There remains” he asserted, “a significant gap between what the UK economy could be producing at full employment and what it currently produces”.  Monetary policy “should continue to be aggressive about promoting recovery and subject to further debate, further easing should be undertaken.  Policy makers should not settle for weak growth out of misplaced fear of inflation”.  The case for further easing in the UK is probably stronger because of the size of the likely fiscal retrenchment to be announced by the UK Chancellor of the Exchequer on 20th October. 

On 15th September, the Bank of Japan intervened in the foreign exchange markets and did push the yen down.  Thus far, that action has not been followed up and the currency is back to its highs.  The Bank of Japan has a lot more to do if it is to maintain any vestige of credibility.  Unsterilised intervention, of course, eases domestic monetary policy and easy monetary policy is a powerful positive for risk asset prices.  The logic of intervention, at its barest minimum, is to try nad persuade the market that the yen should be judged on its merits and not merely be seen as another proxy for investors to hid from the ‘currency war’. 

Despite all sorts of alarms and excursions, the western banking system has repaired itself substantially and is resuming its normal lending role.  The various Global Loan Officers surveys from US Federal Reserve, ECB and the Bank of Japan all suggest that lending standards are improving. 

Preliminary US data shows that credit advanced through August even if it is still 9% below the October 2009 peak.  Consumer credit and commercial paper are picking up strongly even if other sources of credit, like securitisation, are weak.

Banks, of course, continue to focus on their own capital position and will try to keep ahead of regulatory requirements.  Although the full implementation of Basel III has been delayed, a tighter definition of what constitutes risk weighted assets probably means that banks, particularly investment banks, will have to be conservative if they wish to maintain their tier 1 ratio at current levels.  Credit Suisse have estimated that their total risk weighted assets post Basel 2.5 and 3 adjustments are now likely to be around CHF 400 billion – if applied to current positions and before any mitigating actions.  This, in turn, implies that tier 1 capital as a proportion of the banks’ balance sheet will drop.  Previous guidance had been for closer to CHF 300 billion in risk weighted assets.  Barclays have said that market risk and other Basel III changes will add £150 billion “before any management actions”.  Previous guidance had been for £60 billion.  For the time being, pressure to conserve tier 1 capital remains strong and we should expect further ‘management actions’.

Low interest rates have all sorts of other effects beyond the raw impulse to reignite risk taking.  The CEOs of large US companies are starting to react to the low rates of return they are earning on their cash balances.  In August and September, there was a surge in M&A activity with a total of $91 billion in the US alone. 

Unsurprisingly, many of the larger deals have taken place in the technology sector where cash held on balance sheets has reached excessive levels.  One may question some of the logic of individual transactions.  Intel’s purchase of McAfee is a deal that seems to lack obvious business logic.  The likely cost to Intel is $6.6 billion and the price represents a 60% premium for McAfee shareholders.  However, given McAfee is expected to earn net income of $390 million in 2010, rising in 2011 by another 11%, the return on Intel’s investment will be almost 7% in 2011, well in excess of the 20 bps the company might otherwise earn on its $18 billion cash pile. 

Other deals appear to have more strategic reasoning.  A bidding war for data storage systems company 3PAR Inc broke out in August between Hewlett-Packard and Dell.  Hewlett was the eventual victor, paying $2.1 billion or a 40% premium to 3PAR’s pre-bid price.  Even this deal appears to provide Hewlett with a better return, given the profitability of 3PAR, than it had been earning on its cash.

The point of all this is that equities look cheap relative to fixed income assets in any environment other than a truly deflationary one.  Bank of America has made the point that the S&P500 earnings yield is now equal to the average junk bond yield, while the dividend yields on the Dow Jones index is now greater than the yield on 10 year US Treasuries.  The incentive is clearly to seek finance in the debt markets not the equity market.  Indeed, it makes sense to borrow money if only to buy back shares.  Unsurprisingly, new equity issuance in the US in the third quarter was down 17% on a year ago but bond sales totalled a record $861 billion, with the high yield component up 87% to $198 billion.  Earlier last month, Microsoft sold $4.75 billion in record low coupon bonds to help finance share repurchases.  Less equity and more demand is a formula which ought to push equity prices higher.

There is a similar rise in M&A activity in the UK.  Chloride, a producer of power protection equipment was bought for $1.5 billion by Emerson of the US after a bidding war with ABB. The premium paid was 75%. Datacash, a processor of e-commerce payments has been bought on a 60% premium by Mastercard for just over $500 million, while Tomkins, a diversified industrial component manufacturer, was bought for $4.5 billion by two North America private equity firms.  The premium to the recent market value of the company being acquired was well over 40% in all cases. Typically the UK market, excluding the ten largest companies, trades on a price-earnings ratio of 10-12x, while transactions appear to be occurring in the 15-20x range.

On 2nd August, we launched the Melchior Global Equity fund, which is managed by Nick Mottram, who has had a long and distinguished career.  The thought process behind this fund is straight forward.  The objective is to beat the MSCI All Countries World index by selecting stocks based on a variety of criteria, designed to identify wealth creating companies around the world.  There is no top down global asset allocation overlay.  The allocation is determined simply by the logic and attraction of the underlying stocks selected.  In the two months since launch, that fund has outperformed its benchmark by 3.4% giving a return in sterling of 7.6%. 

Intriguingly, though, the regional asset allocation of that fund is remarkably similar, albeit arrived at differently, to the allocation of our active and balanced funds.  The biggest overweight emphasis is currently on equity investment in Asia ex-Japan, within which there is a significant emphasis on Hong Kong listed Chinese shares, Indian shares and Korean stocks.  There is a bias towards mid cap stocks.  On a sectoral basis, it is overweight in consumer discretionary and industrial stocks and modestly overweight in technology and materials stocks.  There is very little in Japan.  North American equities are neutrally weighted.

September was a spectacularly good month for equities in Asia ex-Japan and for materials and natural resources.  Our Melchior Asian Opportunities fund rose 13.53% versus an index up 10.42% and our natural resources fund (MST Resources fund) was up 16.75% – all in US dollar terms.

Our balanced funds are close to their maximum permitted weight in equities.  We have some gold where we cannot hold equities.  Our bond exposure is minimal. 

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.