“We’re leaving together
But still it’s farewell
And maybe we’ll come back,
To earth, who can tell?
I guess there is no one to blame
We’re leaving ground (leaving ground)
Will things ever be the same again?
It’s the final countdown”
September ended in many ways where it began, only worse. The same events dominate the headlines. All eyes are on Europe and each tortuous step towards Greek default and the implementation of a eurozone structure to prevent contagion across the banking system and other indebted nations. Meanwhile further signs of slowing growth are revealed, both in the developed world and, more worryingly for investors, in the developing economies who were providing the strong demand for resources, technology and luxury goods which had been the corporate bright spots this year.
These persisting concerns have driven markets lower over the past five weeks. Equities rallied somewhat in the final week of the month, but with an odd skew of sectors and closed very weakly in the United States on the week the MSCI All Countries Index (ACWI) was up 0.2% in sterling, led by MSCI Emerging Markets (up 1.3%), and the financial sector (up 2.4%). Bonds eased off slightly and commodities were down again.
The picture at the end of September is not a pretty one, but what it may herald for October is more concerning. Equity markets fell heavily, with the ACWI down 5.3% and the Emerging Markets down 10.7% in sterling. In local currencies, the S&P 500 was down 7.2%, the Euro STOXX 50 was down 5.3%, the FTSE 100 was down 4.9% and the Hang Seng was down 14.3%. In Japan the Nikkei was off a more modest 2.9%.
Commodities fared worse. Oil was off over 10%, and copper was down nearly 25%. Gold dropped 11% to end the month at $1620, and platinum (down 18%) and silver were worse (down 26%). Bonds as a whole produced positive returns over the month, with the yield on the US 10 year dropping from 2.2% to 1.9%. The best returns were at the far end of the yield curve, with the US 30 year yield declining from 3.6% to 2.9%, partly in anticipation of the Fed’s Operation Twist, and partly reflecting the downshift in economic growth expectations.
Greek bonds were a bit hairy, as the yield on the one year hit 135% on Friday 22nd September. And the best returns in September? The US dollar which S&P’s August downgrade notwithstanding was up 6.8% against the euro, and 4.3% up against sterling.
Heading into the summer, the profitability and growth of companies in most parts of the world had rebounded strongly in 2009 and 2010 and seemed pretty robust. Valuations based on these levels were not at all stretched, and profit momentum, both realised and expected, was positive, despite rising inflation concerns and the Japanese earthquake. There were some strong stock and sector price trends in place, even if equity markets overall were beginning to look range bound.
Where do we stand now? Heading into the autumn economic headwinds clearly threaten company wealth creation, restricting growth and profitability, and profit momentum. Valuations are undemanding. The historic earnings yield on the ACWI is currently 9%; the dividend yield is 3%. These are not at all time low levels, but when compared to a US 10 year bond offering a yield to redemption of 1.9%, the risk premium for holding equities seems pretty attractive.
Earnings are still forecast to grow for this year and next year by about 14%. Whether these growth forecasts survive the next earnings season is another matter. Earnings revisions over the past month are -3%. Everywhere market, sector and stock price trends have been broken, with previous winners rolling over and previous losers spiking up. Volatility shot up in September, with the VIX ending over 40.
What matters most to the marginal buyer who could capture the equity value gap are the negative momentum and the fear of uncertain outcomes in two areas. Europe continues to dominate. There was progress last week as several eurozone parliaments approved the July deal to expand the powers of the EFSF. The European markets, and especially the banks, rallied after the G20 meeting and the trailing of outline plans to beef up the EFSF, potentially leveraging it significantly, and using the ECB as well to buy bonds and provide liquidity to the European banking system.
The reality is that this “big plan” won’t be unveiled until the November G20 meeting. In the meantime Greece is struggling to nail down its budget targets in order to receive its next tranche of aid. Without this €8bn Greece will run out of cash on 14th October. The officials of the eurozone, ECB, and the IMF no longer talk about avoiding Greek default. Their task now seems to be how they manage an inevitable default and limit its impact elsewhere in the system. If they achieve this “fire break”, then the actual Greek default could produce the cathartic low that equity markets now seem to be looking for.
The extra twist towards the end of September that caused commodities and the materials, capital goods and consumer discretionary sectors to plummet, was the increase in bad news out of and about China. China represents about 15% of global GDP, but with a far higher growth rate (forecast at 8-9%) than the developed world. Since the massive liquidity injections of 2008 Chinese policy has been tightened to prevent inflation getting out of control and asset price bubbles developing. This has had the consequence of slowing the rate of growth in the one part of the world that seems to be the source of positive earnings for companies in Europe and the United States.
And yet despite this there are concerns over the fuzzy areas of the Chinese lending market that are beyond effective central control. The appetite for credit is clearly enormous, and the fear is that a collapse in property prices will trigger a credit problem. The impact of these fears is clear in the Hang Seng’s 14% decline in September. Ron Napier of Napier Investment Advisors pointed out last week that Hong Kong’s domestic credit growth reached an amazing 70% of GDP. Unsurprisingly house prices there are up 70%. The fear is of either a deflating bubble or a relentlessly tight policy creating a hard landing in China.
Ron also reminded me in our meeting of the old investment adage that price drives perception. Equity prices are currently going down.
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