Global Outlook - December 2012

As we try to make sense of the year ahead, we run the risk of extrapolating the experiences of the last 12 months.  We are of the view that we are entering a very different environment.

The behaviour of markets in the last three months has been hinting of this but the overlay of uncertainty from the irresolution of the US budget negotiations has partially obscured this change.

We believe shares will be rewarding in the year ahead based on:

•             Economic factors

•             A change in risk tolerance

•             Attractive valuations

Across the globe the effect of cheap money is working its wonders to re-ignite capitalist instincts.  On a GDP weighted basis, the level of Central Bank rates are just over 2.1% compared with about 5% at the onset of the GFC.  Industrial production is running close to the peak of 2007/08 and global trade is flourishing with exports up some 30% since 2007.  This is not the popular image of world economic affairs but to some extent this is due to the rolling nature of deleveraging that has been taking place over the last five years.

Take for example Ireland; the economy is expanding again, though from a base that is 20% off its nominal peak as surging exports have more than offset government retrenchment.  (The fiscal deficit is presently at 8%, down from 30% immediately after the crises).  The big difference between Ireland and its more challenged peers in the Euro monetary system is its highly deregulated markets, particularly labour, low corporate taxation and fluid population movements, notably among ‘guest workers’.  We do not envisage the troubled countries of the Euro zone to respond with such agility principally because of the nettled issues around labour but even here change is afoot.  In Ireland, for example, unit labour costs are down 10% since the crises whereas the best comparable performer in the Euro zone is Spain where they are down by 3%; while in countries like Italy and Greece, unit labour costs have continued to rise.

We have previously expressed our positive views on the US economy with the recovery in house values and building activity, credit growth, the bonanza from tight oil and gas, the inevitability of an investment recovery and the likely return of some manufacturing jobs onshore.

More broadly, the governments of the large developing economies like China, India and Russia are also taking measures that attempt to correct some of the imbalances that have evolved.  While they will be challenged to meet their ambitious growth targets, the ubiquity of the web and wireless adds to the urgency for action among the ruling elite.  While world growth will be mottled, in aggregate we can expect an overall rise of say 2.5-3% in real terms.  So on the one hand, growth in parts of the developed world may be elusive on account of continuing deleveraging and the withdrawal of government supplementary spending.  However, the continuing growth in the developing world with its concomitant need for natural resources will give rise to many favourable investment opportunities.

From this perspective there is a high probability that we are on the cusp of a redirection of investment flows.  Investor confidence is generally improving as evidenced by falling volatility and a dramatic divergence of stock price behaviour in stark contrast to 2011 when convergence prevailed.  Bonds have enjoyed an unusually long bull market, culminating in a fear-driven crescendo of retail flows to a ballooning population of bond funds.  With the concerted efforts by the Central Banks of the US, Euro zone, Britain and now Japan to suppress interest rates and their currencies, it seems highly likely that bond markets are about to face more challenging times.  While evidence of rising inflation is still remote, and the general view is that it is unlikely to reveal itself until resource utilisation is more intense, it is interesting that house prices are drifting upwards.

A country that may be an interesting lead indicator is New Zealand.  In this small, yet open economy, where new supply of housing has admittedly been constrained, house prices are about 10% above their pre-crises peak levels.  Credit growth in the last year has been modest at 5%, retail sales are soft, unemployment is at similar levels to those during the Asia crises at 7.3% and exports are struggling.  Strangely, house prices elsewhere are also tending to creep upwards in the face of stagnant real incomes.  We suspect that the full effects of concerted liquidity creation by Central Banks will only be appreciated well after the event.

While investors have been forsaking the stock market in droves, the companies themselves have been notably active in buying back shares and more recently in the US, raising their dividend payouts.  From the beginning of 2006, cumulative flows out of equities in the US have been estimated at about US$550 billion, while corresponding flows into bonds have been over US$1 trillion.

The interesting question is the extent to which a rise in bond yields might have a negative effect on equity valuations.  Our view is that there is significant scope for yields to back-up before the yield on bonds adversely affects equities.  The key observation is that bond yields are at record lows as a consequence of extreme risk aversion.

As confidence gradually returns, the willingness of investors to lend to their governments in exchange for say 1.8% pa for 10 years will subside.  Investors can point to about half of listed stocks in the developed world that offer dividend yields greater than their government’s bonds.  Admittedly this has been true in Japan for some years to no avail but the difference lies in the concerted effort to create liquidity.  In addition, sceptical investors like Platinum cannot figure out how the explosion of the money-base will not result in fears about inflation.  Even now, prices keep rising with seemingly low capacity utilisation.  This leaves bond holders poorly rewarded at current yields.  Do note that even without heavy printing, consumer prices in the US since World War II have risen by 3.6% pa compound!

The last building block for our optimism lies in compelling valuations.  We have recurrently voiced our concerns about the sustainability of record corporate profitability, and the need in some cases to normalise valuations for this factor.  However, there are many areas where this is less evident.  In the case of Japan, profitability has been suppressed by the high value of the Yen.  Even in the face of this burden, remarkably, profitability has been rising and now with the Yen weakening, there will be groups of companies that really flourish.  In addition, the flow back of funds can be expected to be particularly sharp as domestic investors flee from bonds and foreign investors scamper to get their weightings back to the benchmark.  Even though foreigners have been accounting for the majority of turnover in the Tokyo market for some time now, surveys show that they were underweight, though keen buyers into the year’s end.

Our quant work shows most markets to be attractively priced and within markets, some sectors are compellingly cheap.  We believe our exposure to these will reward us in the months ahead.

DISCLAIMER: The above information is commentary only (i.e. our general thoughts). It is not intended to be, nor should it be construed as, investment advice. To the extent permitted by law, no liability is accepted for any loss or damage as a result of any reliance on this information. Before making any investment decision you need to consider (with your financial adviser) your particular investment needs, objectives and circumstances. The above material may not be reproduced, in whole or in part, without the prior written consent of Platinum Investment Management Limited.