Market Update - April 2013

With signs of improving economic activity and a change in risk tolerance, what can unsettle the seemingly finely balanced opportunities in world markets? Kerr Neilson discusses the key considerations.

In December 2012 we highlighted the likely shift of funds away from cash and perhaps bonds into equities, caused partly by unsatisfactory yields but more importantly, because of improving sentiment.  There has been a change in perception about tail risk (market disruptions from unexpected sources) and a widely acknowledged acceptance that the principal Central Banks, now whole heartedly joined by the Bank of Japan, will do what is necessary to suppress interest rates until their economies begin to grow again.  This realisation has encouraged investors to push-up share prices well-ahead of earnings revisions.  In other words, the surge in share prices since August 2012 has been mainly driven by the price-to-earnings ratio expansion.  It is not that hope has buried fear and this can be shown by the continuing preference for defensive companies, which are now at extreme valuations, both absolute and relative, to their long-term history, a 30% premium in fact.  At the same time, companies with more cyclical characteristics reveal some evidence of neglect.  The interesting point here is that this valuation bias is as true in the US as in other markets.  This is strange given the fact that US companies have delivered the most impressive earnings improvements since the crisis and that the market as a whole has expectations of low anticipated variability of returns in share prices, as predicted by the VIX volatility index.  This probably means we should expect some rotation to other markets in coming months as their underlying fundamentals gradually improve.  As it stands, markets are displaying a fine balance between gradually improving expectations but with sentiment still tinged with uncertainty.  Valuations in markets outside the US are 15 to 20% lower; this should provide upside potential.

In the December 2012 quarterly report we expressed general optimism based on improving economic factors, change in risk tolerance, and attractive valuations.  While the latter has deteriorated somewhat in the intervening three months because of strong upward share price moves, prospects for the other two variables have probably improved.

What can unsettle this seemingly finely balanced opportunity?

As a sense of well-being is predicated on Central Banks maintaining control of cheap money and encouraging credit growth, anything that disrupts this intravenous feed can be expected to unsettle markets.

• Inflation is seen as the most likely disruptive threat but it needs great selectivity of data to find evidence of it picking-up speed.  Even in countries with relatively weak currencies like the United Kingdom, inflation is still remarkably subdued reflecting under-utilised resources while in the US, the general price index seems to be heading lower.

• Ironically, the more subdued growth rates in emerging markets, together with a strong supply response to recently elevated prices of commodities, is helping to subdue raw material prices.  So while demand continues to grow, for the moment it seems that supply is more than adequate.  Improved energy self-sufficiency for the US is the big topic of the day but we should not lose sight of the fact that the supply-demand balance for liquid hydrocarbons is as tight as it has ever been.  The gap between supply and demand globally is a mere 2 to 3 million barrels per day out of consumption of 87 million barrels per day.

• Political disruption could be another destabiliser and here again one would be hard pressed to identify wide-spread civil unrest caused by fiscal austerity.  In fact, the European Union seems to be softening its position on budget deficits and seems willing to extend the time scale for fiscal rebalancing.

• Earnings shortfalls cannot be ruled out and analysis of the extraordinary resilience of US company profits reveals that productivity gains have been kept by companies.  Obviously European and Japanese companies do not, as of yet, have the same buoyant domestic economic conditions.

• Currency manipulation which causes undue competitiveness could also produce negative surprises for corporate earnings.  With the weakness of the yen, European manufacturers face renewed competition which must impinge on their profitability.  By the same token, a strong US dollar will have some adverse effects on foreign earnings translations as well as international competitiveness for US-based companies.

• Suppression of borrowing costs to well-below long-term clearing levels seems bound to create misallocation of capital but this for the moment is a more distant threat.  By way of example, the search for yield is enabling emerging countries which were former credit out-casts to sell sovereign bonds at well-below double digit yields and indeed companies within these countries are engaging in cross-exchange borrowing.  This over-dependence on foreign funding was indeed the cause of problems for parts of Asia in the late 90s but it is our view that is far too early to make a similar call.

It is not as though we have become born-again believers in quantitative easing as we remain convinced that the steps now being taken, to ameliorate what is essentially a deleveraging cycle, will have some longer term negative consequences, particularly the misallocation of capital.  However, markets are still tinged with caution and we are finding investment opportunities without having to stretch expectations beyond the probable.  Useful markers in the months ahead may be a weak gold price in US dollars (reflecting improving confidence),relative strength among banks (revealing improving economic conditions and falling solvency fears) and upward trending bond yields (suggesting an improvement in underlying growth and the demand for credit).

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