Rowan Stockmarket and Economic Outlook
April 2007
Stockmarkets around the world have been doing a lot of worrying this year so far. They have been worried about the carry trade, the dollar, China, the US sub-prime mortgage market, inflation and Iran.
The correction in the Chinese stock market triggered falls in global markets. This global correction really was a surprise because the Chinese stock market is very small, the index had grown by over 120% in 2006 and was subject to government interference in the form of potential ‘capital gains tax’ legislation, so a sharp drop should not really have been a great surprise. However it serves to show how jittery markets have been this year.
United States
The biggest concern to date has been the US sub-prime mortgage market. It transpires that credit checks on the majority of borrowers varied between minimal and non-existent, consequently as interest rates increased the “delinquency” (mortgage payment default) rate has risen quite dramatically. This came on top of a US housing market that had slowed dramatically, which resulted in a backlog of unsold new homes.
The sub-prime market gives two causes for concern. Firstly the financial impact on the institutions that hold the debt and secondly the impact on the US economy. On the first point, much of the debt had been packaged into ‘CDOs’, (collateralised debt obligations). CDOs were designed to reduce risk to the holders of the debt whilst providing a higher yield. To date these structures have held up very well with no fallout and it would seem unlikely any will follow now. The second point is much harder to judge; home buyers who are struggling to meet their monthly mortgage payments are not going to spend on household goods, and those who are having to sell their properties because they cannot afford repayments are almost certainly going to struggle financially and not “spend.” The question therefore is how much of an impact this will have on the overall US economy: throw into the equation the fallout from the wider housing market and it is possible to make a case to suggest the impact will be quite significant but delayed.
UK
The UK mortgage market does not suffer from the same problems as the US market because lending criteria have been much stricter and the UK market is driven by demand, which is outstripping supply, whereas the US market has an oversupply of new property.
The performance disparity between mid-cap and large cap stocks continues with mid-cap stocks on valuations that make them as expensive as at the top of the market in 1999, whilst large cap valuations are at a 20 year low. It is important to point out that large cap stocks (FTSE100) can be split into two broad groups, the mega-caps (the top ten largest stocks) and the remaining 90 stocks within the index. It is the mega-caps that offer significant value on a historical basis, whereas there is very little to distinguish between large mid-cap stocks and smaller FTSE100 stocks on valuation grounds. Over-valuations and under-valuations tend in time to be corrected by the market but periods of “irrational” behaviour can continue for a long time.
Inflation in the UK continues to be a cause for concern with the very latest inflation figure coming in at 3.1% which means the Governor of the Bank of England has to write an explanatory letter to Gordon Brown as to why inflation has risen.
The other news to dominate the UK recently was the capture of British naval personnel by the Iranians which added to tensions in the Middle East. This in turn helped to push the oil price up to $68 a barrel over a period of two weeks. At the beginning of this year the oil price was $60 a barrel, by the third week in January it had fallen to $52 a barrel so the current price of $68 is a 30% rise from the lowest point this year. In the US this has meant gasoline prices rising from $1.40 a gallon to $2.30, a 64% increase. An equivalent rise in the UK would result in petrol prices of approximately £1.50 a litre!
In broad terms equity valuations look attractive when compared with bonds although if inflation continues to rise and interest rates are raised to counter this, the balance may swing in favour of bonds.
Europe
Europe has been having quite a good time; employment has been growing along with retail sales although the VAT hike at the beginning of this year in Germany has stalled retail sales there. Provided the German economy continues to progress this should only be a temporary setback.
Interest rates in the Eurozone are 3.75% and expectation is for a further increase of 0.25% to 4% in June. Economic numbers vary from country to country. The most recent manufacturing output numbers in France were better than expected whilst in Italy they were poorer although across the Eurozone output increased.
Europe remains an area in which fund managers are able to find high quality under-researched companies because of the sheer number that exist and the geographical and industry diversification the region offers. The continuing emergence of Eastern Europe is providing companies within Western Europe with increasing opportunities and Europe remains one of our favoured areas.
Japan
The Japanese economy continues to struggle despite the consensus view that Japan is significantly better positioned than in previous years. Interest rates are currently 0.5% and will stay at this level until inflation shows signs of gaining ground. However the latest inflation data saw a number of consumer prices remaining unchanged and some falling. The domestic economy remains muted as confidence remains subdued.
Far East and Emerging Markets
The Chinese Central Bank raised its lending rate by 0.27% to 6.39% the third increase in a year. Retail sales remain strong but there was a sharp drop in the annual growth of exports which may be attributable to the ending of tax rebates for exports suggesting that Chinese companies have “front-loaded” shipments into the end of 2006 and early 2007. This will be a crucial figure to watch but at present is not causing undue concern.
Summary
Equities represent good value in virtually all markets compared with bonds and the global economic outlook remains stable. Company earnings in 2007 will be less than in 2006 but this is already factored in. There are risks which could change the outlook; inflation is the one to watch most closely because rising inflation will result in central banks increasing interest rates and this has the potential to impact the global economy on a broad base. The other indicator to keep an eye on is rate of growth in Chinese exports; the recent drop in exports could be purely technical but it may be the first signs of a changing trend and is therefore an important indicator.
Rowan Investment Team
April 2007
Past performance must not be taken as a guide to future returns.
The views and opinions expressed in this article are those of Rowan & Co. Capital Management PLC. The information concerning taxation treatment is based upon our understanding of current law and HMRC practice. Levels and bases of, and relief's from, taxation are subject to change. The amount of any relief will depend upon individual financial circumstances.
Because these investments and the income from them may go down as well as up, you may not get back the full amount invested. Because of the volatile nature of some of these investments, you may receive nothing at all.
This article is intended for information purposes only; it should not be taken to construe advice and it does not constitute a recommendation to buy, sell or otherwise transact in any of the markets and/or sectors referenced.
