Market Review 20 March 2012

Commentary: Pity the Land In Need of Heroes

Entering the third week of March equity markets have spent the month working higher. The S&P 500 reached its highest level since early 2008 and the NASDAQ it’s highest since late 2000. Global equities, represented by the sterling total return on the MSCI All Countries World Index, are up 2.2% month-to-date, with US equities in the vanguard, and developed markets outpacing developing, although still behind the latter in 2012 (nearly 11% plays 14%). Financial and IT stocks have been to the fore with energy and materials bringing up the rear. The MSCI China index is off over 2%, as is India. Government bond yields have risen this month: the US 10 year yields 2.3% now compared with 1.9% at the start of the year.

We are a long way from the “bond bubble bursting” as some headlines have characterised it. UK newspaper speculation about the issue of a new 100 year gilt framed the challenge posed by current government bond yields for any investor with an eye on both the longer term and the gravitational pull of fair value. Today’s UK inflation release showed CPI slowing but still at 3.4%. The UK 30 year gilt offers a yield to redemption of 3.5%. Is a real yield of zero a good place to start? The UK equity market currently offers a dividend yield of 3.5%.

Are these equity market flourishes the last knockings of the positive liquidity policy actions since last October? These moves have come on the back of low volumes with little sign of a significant reallocation to equities, although State Street note in their latest asset allocation piece that institutions have started selling US Treasuries. And they describe the general tone of institutional flows has been pro-“risk”: net purchases of corporate bonds, cyclical equities and European banks. If equities continue to outperform bonds allocation flows into equities as a whole may start to support further gains.

So far all we have seen is a recalibration of risk, as the liquidity crisis in the eurozone has receded from the front of investors’ minds (and taken with it the immediacy of solvency fears). Of course, the absence of fear does not indicate the absence of risk, and I’m sure The Euro Part II (and Part III) will appear at cinemas in due course.

The immediate economic prospects remain cloudy, as articulated by the FOMC last Tuesday. US retail sales and job numbers are solid if unspectacular. Longer term – beyond the Presidential bun fight – concerns over the budget remain.

What could reverse the positive trajectory of equities? Obviously another eruption in Europe, perhaps as austerity begins to bite and the political cycles begin to accelerate, but geo-political concerns elsewhere, notably around Iran’s nuclear programme and oil supply.

The biggest hurdle to an investor looking beyond the ebb and flow of short term political and economic noise has to be a concern that returns on equity capital will decline in the developed world as the debt bubble continues to deflate. Corporate profit margins remain high – data provider FactSet shows the operating margin on the MSCI ACWI at nearly 12% currently – while sales growth has unsurprisingly slowed, to just over 7% year-on-year per Factset. This compares with the annual run rate of 18% recorded last September.

Liquidity injections have stabilised global credit and equity markets, anaesthetizing some of the pain of adjusting debt burdens. The next challenge will be a transition to underlying growth. The short-term bumps that could throw investors include the drag of higher oil on the Far East, the fear (rather than the reality) of a Chinese slow down becoming a hard landing. These jitters won’t have been eased by the earlier announcement by Premier Wen Jiabao of a reduced growth target of 7.5% and the rise in Chinese fuel prices for the second time in six weeks. China is the biggest consumer of energy and steel.

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