August was not a holiday month for global investors, unless you believe that a violent change is as good as a rest. Global equities, represented by the total return on the MSCI All Countries World Index (ACWI) in sterling, ended the month down 6.6%, having been down over 14% at one point mid-month. Emerging markets as whole did badly, down 8.2%, but Europe and Asia ex Japan fared worst.
The German DAX was down over 18% on the month, in sterling, compared with the S&P down 4.7%. Financial stocks, particularly European and US banks, as well as energy and industrial stocks took the brunt of the poor performance at a sector level. The safe harbours of the highest rated government bonds, inflation linked bonds, and gold benefitted from the flight for safety. The US 10 year gained over 3% in the month and gold was up over 10%.
The last week and a half saw a very sharp rally in equity markets, and the biggest gains, although choppy, came in the US as technology, and bank stocks did well. Apple shrugged off the announcement of Steve Jobs stepping down as CEO, and Warren Buffett invested $5bn in Bank of America after it had fallen on concerns over legal repercussions for its past practices of mortgage selling and subsequent foreclosures. Elsewhere equity markets rose, but not by as much.
The safe harbours of early August fared less well. Government bond yields rose, and gold and silver both ended the month off their highs. Gold had a wild ride in the final week. On Monday 22nd it reached a new high at over $1900 per ounce, before retreating by $200 over the week in the face of profit taking and increased margin requirements. However gold is still up 25% in 2011 while the ACWI is down nearly 8% and the US 10 year is up 5%.
August was the moment when investor confidence evaporated. Two factors finally came into sharp and combined relief: the continuing fragility of the economic recovery in the heavily indebted developed nations, and the inability or unwillingness of many politicians in those nations to confront or solve the underlying problems left over from the 2008 liquidity crisis.
The world had a disappointing glimpse behind the political red curtain, whether it was the technicality of raising the US debt ceiling, or the organising of assistance by the strongest for the weakest members of the eurozone. The climax to the bitter ideological scrap on Capitol Hill over the debt ceiling was, just, resolved by the August 2nd deadline and a US default avoided.
But that weekend S&P downgraded the US credit rating. Faced with the “peripheral” crisis spreading beyond Greece and Portugal to Spain and Italy, and with the Italian ten year bond yield jumping above 6% at one point, the eurozone responded with a new initiative by the ECB to buy Spanish and Italian bonds.
Although each mini crisis was avoided, investors were forcibly reminded of the fragility of a developed world where recovery was not assured, where real GDPs in the major economies had not recovered to pre-crisis levels, and where big problems – whether the US housing slump, persistently high unemployment or squeezed real incomes – remained.
Confidence disappeared, and investor time horizons shortened. There was a full flight to safety. Instead of mild concerns over sovereign credit and the rate of developed world economic growth, the fear of everything took hold. Any concerns over the impact of deficits on government credit ratings became subordinate to concerns that economic growth is stalling once again. Equities were sold and bond yields in the major developed world went to new yield lows.
Ten year bonds ended the month at the following levels: US at 2.2%; German at 2.2%; UK at 2.6%; Switzerland at 1.1%; and Japan at 1.0%. Global equities are priced on a forward PE ratio of 10.5x and a dividend yield of 2.6%, with Europe and the UK both on 8.5x next year’s forecast profits. Even on historic profits, global equities are on 11.8x.
What next? The sovereign debt burdens of the developed nations have not caused investors to shun bonds and buy equities which appear attractively valued. Instead they have bought these bonds because they fear a sharpening of fiscal policy to deal with these debt burdens, which will produce even weaker economies with corporate profits declining.
There have been signs of weaker economic growth – the US grew at an annual rate of just 1.3% in the second quarter – and data announcements are received with concern. Broker earnings forecasts collected by Factset indicate that investors still expect corporate profits to grow by 16% in each of the next two years, although the earnings forecasts have been revised down by 1.4% (in local currency) in the past month. The behaviour of markets clearly indicates that investors anticipate poorer results seasons over the next six months.
There was some reassurance taken by markets from Fed Chairman Bernanke’s speech at Jackson Hole, which essentially restated the FOMC announcement of two weeks before when the Federal Reserve announced that it would keep rates close to zero for at least two more years, citing economic weakness, and restating its preparedness to use other policy tools, by implication QE3, to respond to a worsening economy. It seems that the Fed is in a wait and see mode, and QE3 stimulus is only likely if their forecast outlook is proved wrong. Their biggest fear remains deflation.
Whilst the fear must be of weaker economic data announcements for the rest of this year, this has already been priced in to an extent. There is also the prospect of some benefit from the absence of the factors that occurred to depress things in the first half: the Japanese earthquake and the spike in the oil price.
One area of concern is China. The world’s second biggest economy, whilst not running at the same clip as recently, is still likely to grow at more than twice the rate of the developed world but their policy bias is still to combat the threat of inflation. Last weekend the People’s Bank of China announced a further rise in the reserve requirement for domestic banks.
The month of September sees a number of significant signposts for markets. On September 1st there is the Global PMI data announcement, including ISM New Orders; on September 2nd we get the latest US employment data. On September 8th there is the ECB meeting, revealing their latest growth and inflation expectations, and on September 21st the two-day FOMC meeting announced at Jackson Hole. On September 29th the German Parliament votes on EFSF changes, and other European parliaments also start voting on EFSF changes during the month.
Issued by: Rupert Caldecott, CIO of the Global Asset Allocation Team, Dalton Strategic Partnership LLP, an investment management boutique in London founded in 2003 by the late Andrew Dalton