Commentary: Going Faster Miles an Hour
January 2012 has ended and it’s worth taking stock of where returns, valuations and economic data stand before considering the swirl of news that can confuse as much as enlighten. Equity markets shrugged off a poor 2011 and posted strong gains. The broad MSCI All Countries World Index was up 4.2% in sterling over the month, led higher by emerging markets, and recovering a good deal of 2011’s 6% fall. The MSCI Emerging Markets Index itself was up 9.7% on the month, taking a big bite out of the near 18% decline in 2011.
The major emerging markets did well as eurozone fears abated, economic data was encouraging and the monetary policy easing cycle continued: Brazil was up 13.5%, Russia +13%, India +19% and China +9%. On a regional basis Asia Pacific ex-Japan was up 8.2%, led by India and China’s strong performance and with Hong Kong up 7.8%; Korea up 8.9% and Taiwan up 7.3%. The two island nations, Japan (+2.9%) and the UK (+2.0%) were the laggards. The yen continued to strengthen, by just under 1% to 76.25 to the dollar, dampening equity returns in sterling.
The renewed appetite for risk abated somewhat in the last week of the month but still the VIX fell from 23.4 at the start of the year to 19.4 at month’s end. The sector performances bear this out: Materials and Diversified Financials led the way, both up over 10%, with Semiconductor’s up 8.2%, Banks up 7.6%, and Cap Goods up 7.1%.
The eurozone saga continues. This week sees another summit where negotiations will aim to finalize the fiscal compact and the discussions between Greece and its “private” bond holders about agreed write downs continue. The markets took a more sanguine view. While the Greek 10 year bond yield hardly moved, the equity market surged 23% (in sterling). Whatever (and whenever) the outcome of PSI negotiations the outlook for Greece is bleak, with suggested external supervision of its budget and pressure to further cut government spending and axe public sector jobs.
The IMF’s latest Global Financial Stability Report published on January 24th was titled “Deeply Into The Danger Zone” and stated that “sovereign financing remains challenging and downside risks remain. If funding challenges result in a round of deleveraging by banks, this could ignite an adverse feedback loop to euro area economies”. The report does acknowledge the impact of the LTROs in mitigating funding stress.
Another round of bank funding via the ECB’s LTROs is due on February 29th, with the €489 billion raised in December likely to be eclipsed, perhaps €1 trillion will be raised, as European banks look to get ahead of their funding requirements. This liquidity relief buys time for the sovereign funding issues to be addressed more in line with the speed of the political cycle rather than the speed of the market’s cycle. At the same time the IMF downgraded their forecast for the growth in global output in 2012, from 4% to 3.25%, mainly due to the euro area problems and their spill over effect on other regions.
The UK’s latest GDP data, down 0.2% in the fourth quarter of 2011 showed the impact of austerity measures in a fragile environment, with the proximity of Europe adding to the domestic weakness. Perhaps the most resilient to any European spill over will be the US, which has continued to produce moderately encouraging economic data, although it reported real GDP for Q4 2011 of +2.8% (nominal 3.2%), shy of the consensus expectation of 3% (nominal 4.0%).
The FOMC cited a weak outlook when they announced that they would be keeping interest rates at near zero levels until 2014 at least unless the outlook for the economy changed dramatically. That will mean six years of extremely stimulative policy, emphasising both the scale and impact of the 2008 credit bubble and the struggle for underlying activity to recover in its wake. Since 2008 the Fed has bought $2.3 trillion in long dated assets and Chairman Ben Bernanke hinted they would purchase more if unemployment remained high (currently 8.5%) and inflation subdued (1.7%).
Operating margins in the US have returned to the all time highs seen just before the 2008 collapse, with FactSet showing the S&P 500 at 13.7% compared with the peak of 14.4% in July 2007. Real GDP in the US has finally recovered to 2008 levels, but business fixed investment is lagging. How long can these peak levels of profitability be maintained as unit labour costs have started to rise and reinvestment is needed to maintain productivity and boost growth?
The Q4 2011 earnings reporting season is in full flow in the US, and starting soon in Europe and the UK. According to ISI the bottom up estimate to S&P500 companies’ earnings has increased to 11% year-on-year – with Apple and Caterpillar producing big positives – whilst sales revenues have disappointed, with just 38% of reporting companies beating forecast revenues compared with 46% when Q3 was reported.
The picture is less attractive in Europe and the UK, where operating margins are still below their previous highs (12% vs. 13.5% on the EuroStoxx, and 10% vs. 15% on the FT All Share, as reported by FactSet). But the problem for Japanese companies is clear: the operating margin that FactSet shows for the Nikkei is 6% compared with a previous peak of 8%. And the strength of the Yen doesn’t help. It has risen 7% against the dollar since the start of 2011 and hampered the efforts of Japanese exporters to recover from the effects of the March earthquake. As a result Japan has announced a trade deficit for 2011, the first in thirty years.
Given the levels of profitability equity market valuations are subdued, reflecting the concerns that it’s late in the recovery cycle from 2008 and there’s a strong headwind to negotiate before profits move ahead again. The ACWI stands on 11.4x forecast earnings and on a dividend yield of 2.7%, whilst the Emerging Markets index is on a multiple of 10.1x and a yield of 2.7%. Ten year bond yields in the preferred “safe havens” have reverted to their lows: the US Treasury yields 1.8%, the Bund 1.8%, the Gilt 1.97% and the JGB is on 0.97%.
Elsewhere the Wall Street Journal reports that the mysterious “people familiar with the matter” have signalled the imminent IPO filing of internet and cultural phenomenon Facebook, a company so “now” that it’s already had a film made about its formation. Facebook is mooted to be valued at $75-100 billion. In 2011 its revenues were reported to be $4.3bn, double 2010’s revenues. Already it has 800 million users, and last year received just over $5 per user from advertisers etc. The net present value of each current user’s future profit contribution to Facebook is therefore about $100 based on the proposed valuation.
Momentum is everything. Until it isn’t and the gravitational pull of valuation takes over. Google’s share price rose sevenfold from its IPO until the credit crunch, and even now is nearly six times its float price. And it does have margins (and revenue growth) to make most company CEO’s weep with envy.
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