Investment Review: Light at the end of the tunnel?

Investment Review: Light at the end of the tunnel?

By Ian Leverington

Ian shares responsibility for Ashburton's International Equity Strategy. In the latest issue of Ashburton’s Perspective, he reviews the past quarter from an investment perspective.

The first quarter of 2008 has seen equity markets continue to tumble as fears of a collapse in the global banking system and a recession in the US have weighed on investor sentiment.

2008 began with a raft of disappointing economic data out of America and global equities fell 15% in a little over 3 weeks. The ISM manufacturing index gave a first signal that manufacturing activity in the US was contracting, falling to its lowest level since 2003. Moreover, unemployment hit 5% and confidence measures recorded growing pessimism, both amongst consumers and business managers.

It is not surprising that US consumers, (for so long the rock upon which their country’s prosperity has been built), have started to feel the pinch of late. They have become accustomed to feeling the ‘wealth effect’, watching the value of their homes rise and borrowing and spending against that. This virtuous circle has now become a vicious spiral. In fact, credit has become harder to access full stop, as banks have sharply tightened lending standards across the board in response to the sub-prime meltdown.

They are also being hit squarely in the wallet as the cost of gasoline and food has risen sharply in response to the continuing huge demand for commodities from emerging Asia. Rising unemployment will also start to play on the minds of the man in the street.

Amidst all this doom and gloom, and against a backdrop of near panic within the banking community, the US Federal Reserve has stepped in and taken decisive action. Since September last year they have cut interest rates by 3% in an aggressive move to stave off a meaningful recession.

The Fed was originally formed in the early 1900’s to address the threat to the US banking system posed by the phenomenon of ‘runs on banks’. As can be judged from their actions in bailing out Bear Stearns in mid-March, they have in effect been forced into this role once more, taking action to unfreeze credit markets by offering to lend against any grade of debt at face value, rather than at the deeply discounted rates offered in the markets.

The Fed has shown that it will support the banking sector at all costs and we believe the settling of this uncertainty will put a bottom under markets. Nonetheless, we are for now maintaining the large underweight position in financial stocks that we instigated in the summer of 2007 across all of our equity offerings.

Outside of the financials we are starting to see the first signs of recovery. Equity markets generally bottomed out in mid-January, and in a second correction in mid-March these technical lows held successfully. We have seen a mini rally in the last two weeks of March, one which might extend given the stimulus of abundant liquidity provided on a concerted basis by the world’s central banks.

Sentiment fell to extreme levels of pessimism in March; these are usually associated with market bottoms. This combined with improving market breadth and participation all adds weight to our belief that we should expect some sort of bounce in markets. It should also be noted that stocks are now as cheap relative to bonds as they have been since 1993. Bond yields certainly look far too expensive, and if we do see some reversion to the mean, equities prices should benefit.

We expect that a combination of liquidity and a lessening of risk aversion will particularly benefit emerging Asian economies. We have been disappointed by the sell-off in markets such as Hong Kong and India over the last few months. These economies have limited exposure to US economic problems and yet have still been subject to the fire sale of supposedly riskier assets, regardless of valuation. We believe they now offer exceptional value.

We are less confident about the prospects for Japan and Europe. Japan has been the perennial underperformer over the last couple of years, despite cheap valuations, a stable (if uninspiring economy) and lately the move away from a deflationary environment. What Japanese markets lack at the moment is a catalyst to kick start a period of sustained strength.

Europe by contrast has performed relatively well, but it now faces the same sort of problems that the US faced 12 months ago, in the form of slowing growth and weakening property prices. Whereas the Fed has cut rates aggressively in the US, the ECB is unlikely to do so and a strong euro currency is likely to weaken the eurozone economy still further. If America is just coming out of the tunnel, one suspects that Europe is just about to enter it. That is not to say that there are no opportunities to exploit in the region.

On the currency front, we have just recently taken good profits from long positions in the Swiss franc and the euro. Our exposure to these lower-yielding, safe haven currencies has worked well as a hedge against the correction in equity markets. We have reduced our yen exposure recently, but are bullish on the yen longer term, given that the carry trade theme is probably dead for now. 

We have been long-time bulls on the growth prospects for China and India and these economies show little sign of slowing any time soon. Both countries have recently employed fiscal policies to keep GDP growth under control, but this will not impact their demand for raw materials and infrastructure spending as the urbanisation of their populations gathers pace.

Nor will their demand for soft commodities or energy resources diminish. Global dry bulk shipping rates (dry bulk typically includes coal, iron ore, wheat and grains) have started to push up again and the persistently strong oil price appears to be driven more by genuine supply and demand issues than by speculation.

Key Points

• Global equity markets have sold off aggressively in the first quarter, but we believe this correction sets us up for a rally at least in the short-term.
• The pro-active intervention of the Fed will protect the financial sector from meltdown, and will limit any slowdown in US economic growth.
• Relative to bonds, equities are as cheap as they have been for many years, and offer good value.
• Emerging Asia has corrected sharply in recent months and we believe this represents a tremendous opportunity to pick up cheap stocks in the most appealing of market conditions.

In Summary

There is some evidence to suggest equity markets have bottomed, but technically the outlook for equities is not clear cut, and with this in mind we are still reticent about committing too aggressively to these markets. In this volatile climate we remain vigilant for a meaningful shift in the weight of evidence back towards equities.