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Market Bulletin - Monday August 22, 2011

St. James's Place - Wealth Management

A time for quiet reflection

Events of the last three weeks have witnessed volatility in global financial markets and it is unlikely that this will change significantly in the coming few weeks. The current problems behind the gyrations in share prices are well known: too much debt (both household and government), political indecisiveness – mainly in Europe and the US – and following a slew of economic data released last week, evidence of slowing growth in the West giving rise to fears about a possible double-dip recession. As a consequence, markets are re-pricing shares to reflect these headwinds and investors are, quite understandably, concerned about the impact of this on their investments and want to know what, if any, action they should take.

Firstly, it is quite normal during times like this to feel we should take some form of action. In bad times the urge to sell can be irresistible – last week saw some investors indiscriminately cashing in as they sought safety. But we know from experience that this is costly when taking a longer-term view because optimum re-entry into the markets is impossible to judge. The Sunday Telegraph discussed the psychology of investing and, as Tom Stevenson of Fidelity observed, “Natural instincts tell us to flee ‘danger’ but, in investing, volatile ‘dangerous’ markets are often a good time to buy as there are opportunities.” This is a view we would endorse.

There is one other strategy you should consider if you are looking to invest in the markets at the current time but are unsure about timing and that is to phase your investment. When market volatility is high, switching to a drip-feed strategy – that is, investing a lump sum in equal amounts over a pre-determined period of time – offers two clear advantages. It eliminates market timing errors and benefits from pound–cost averaging. In other words, when prices are falling, investors can buy more shares or units in their funds.

In any event, please do not hesitate to contact your St. James’s Place Partner if you wish to discuss any aspects of your investments.

Headwinds buffet financial markets

As head of the World Bank, Robert Zoellick is much-respected and clearly experienced in global financial matters but he unwittingly set the tone for what was to be another very difficult and worrying time for investors in the markets. At a dinner last week in Sydney, he fired a clear shot across the bows of leaders in Europe and the US, warning that investors worldwide have lost confidence in economic leadership, driving financial markets into a “new danger zone”. He said he used the words carefully “so that policymakers recognise and take it seriously for what it is”. And as the week unfolded, investors’ resolve was indeed severely tested.

Markets started the week with a degree of composure following the volatility of previous sessions, with most major indices beginning to claw back some of their losses. But poor economic news from the eurozone’s powerhouse, Germany, brought the rally in equities to an abrupt halt. With economists expecting GDP growth of around 0.5% for the second quarter, Germany reported that its gross domestic product grew by a meagre 0.1%. At the start of the year, Germany’s surging confidence raised hopes that debt-crisis-hit southern Europe might be swept along for the ride. With worries rising about global growth and even double-dip recessions in some Western economies, Germany’s growth performance is crucial.

Hopes were pinned on a summit meeting between Angela Merkel, the German chancellor, and Nicolas Sarkozy, the French president, which took place the same day. Global investors were looking for some form of agreement to create a Europe-wide bond (whereby risk would be spread across the 17 euro members) or to increase the size of the European Financial Stability Facility to ensure it had the funds for a Spanish or Italian bailout. Unsurprisingly, in our view, neither was forthcoming and instead the leaders agreed to explore a financial transactions tax, an idea rejected in the past by the EU and the US; and the markets reacted with disappointment. Against this backdrop, investors decided to re-price shares and other risk assets to reflect slowing growth and the lack of a solution to the debt crisis.

But the main catalyst for the subsequent sell-off was weaker-than-expected US manufacturing and unemployment data, which compounded the poor European growth numbers. Investors became worried that if the slowdown turned into recession then European banks would be holding more bad loans on their books which would need to be written off and thus hurt lending. So Thursday and Friday witnessed heavy falls in global equity markets as investors decided to head for the perceived safety of gold, the Japanese yen and government bonds – particularly US Treasuries and UK gilts, where yields fell to levels not seen in 50 years. The yield on the ten-year US benchmark bond briefly dipped below 2% as investors drove prices higher on fears of impending recession in the West.

So with the head of the World Bank telling policymakers to act decisively, what tools do the ECB, the Bank of England (BoE), the US Federal Reserve and leading politicians have to use? Well, according to The Financial Times they are limited. The starting point is too much debt. Consumers in rich countries are paying down debt whilst most governments in the West ran up huge levels of debt and have mostly run out of capacity to create more. So what policymakers need is a tool that will get rid of some of the debt or else persuade consumers to keep spending and let the economy grow its way out of the problem over time. Printing more money – quantitative easing (QE) – has failed to work. In fact it has created commodity price inflation which has hurt consumers and forced retrenchment. However, central banks have committed to keep interest rates at historically low levels – the US Fed has promised not to increase rates until at least mid-2013. With inflation higher than wanted, the likes of the BoE have said it will not sanction more asset purchases (QE) unless signs emerge that inflation is likely to fall below its target of 2%. Last week, inflation edged higher to 4.4%, exacerbating the problems facing the BoE as growth slows here in the UK. The Fed has a similar dilemma too and, as we have stated before, an end to the current round of volatility does require signs of firm and decisive political leadership.

However, we do not believe that the current sell-off signals a re-run of the 2008 financial crisis – the circumstances are different this time. Analysts at BlackRock point out that 3-month TED spreads – the difference between yields on Treasuries (the risk-free rate) and Libor (the rate banks charge to lend to each other) – are very far from the highs seen in 2008. Spreads are currently around 30 basis points against 500 basis points during the credit crunch, indicating there is no drying up of liquidity.

Looking ahead

When capital values fall, attention understandably and justifiably turns to the important contribution of dividends to the total return from equity investment. In a low-growth environment, the demand and opportunities for attractive equity yields are very apparent.

One measure of the level of distress in markets is equity dividend yields rising above bond yields across many developed markets. This usually happens only once in a generation but has occurred three times in the past four years in Europe, according to Citigroup analysts. The dividend yield of the Dow Jones Industrial Average sits at 2.25% versus 2.07% for the ten-year Treasury note – the first time since 2008 and before that since the 1950s. “Whether you look at dividend yields or price-to-book ratios, there is clearly value emerging,” was the view of Andrew Milligan at Standard Life. Indeed, it is possible for investors holding a fund of high-yielding UK stocks to achieve a starting yield of close to 5% (net of basic rate tax) – which can of course be re-invested to boost capital values if chosen – with prospects of a growing income in the future as companies raise their dividends to reflect growing profits. This contrasts sharply with the prospects of owning government bonds where investors are currently guaranteed ultra-low returns (2.2% gross on a ten-year gilt) and capital depreciation if held until maturity.

One other aspect of the recent fall in share prices is likely to be an increase in merger & acquisition activity, as cash-rich companies seek out value. Last week’s bid by US giant Hewlett-Packard for UK-listed Autonomy is a good example. The Sunday Times pointed out that Autonomy is unlikely to be the last British company faced with a pile of American cash. US corporations have an estimated $1 trillion stashed abroad, said the paper, profits from foreign operations that they are unwilling to repatriate because they would have to surrender about a third in tax. The paper opined that there is potentially a long roll call, including the likes of Smith & Nephew, Sage, Centrica and Reckitt Benckiser.

And it’s not just corporations themselves who are on the look-out for a bargain. Company bosses are also taking advantage of the turmoil in global markets to snap up shares in their greatest numbers since the end of the credit crunch. According to data released by Bank of America, Merrill Lynch directors are buying ten shares in their own firm for every one they sell – the highest ratio since the FTSE 100 troughed in March 2008. Company Directors have a good track record of buying shares in their company when they are attractively valued.

Perspective

With the current levels of volatility in the markets it is, as we said at the start, unsurprising that some investors feel compelled to react by taking some form of action. However, it does help to take a step back and reflect on the bigger picture which, admittedly, is not easy to do if we are being bombarded by headlines full of bad news. Mark Evans of THS Partners, along with his colleagues, has taken the opportunity in recent weeks to reflect on current events and think about what they might mean going forward.

“Savers face a perpetual dilemma between risk and reward; between preserving capital and generating growth. The horde of pundits on TV, the internet and in the printed press, offering advice and proffering charts, serve only to complicate the issue. Fashion is part of the problem: human nature encourages us all to pay too much attention to the recent past, and to extrapolate straight lines, irrespective of fundamentals or valuations.

“So, taking a long-term view and eschewing fashion, where should the prudent investor place their money? Where are the greatest opportunities for capital preservation and formation? Will it be in the darling of the day, the commodities sector? Or will bonds continue their 30-year bull run, offering investors a certain return in an uncertain world? Are superior returns to be found in property, putting faith in bricks and mortar, rather than the vagaries of paper? Or could equities – the worst-performing asset class of the last decade – be the one? Could it be that owning shares in profitable, growing companies is the best way to safeguard wealth and earn returns?

Five classes, three choices

“There are five main types of assets: commodities like gold, silver and copper; cash itself; property; bonds from governments, companies and the like; and shares in companies. All but the first are productive assets, in that you – the investor – are paid to hold them. (Cash is a productive asset if, and only if, you are prepared to lend your money to a bank.) If you are an investor in property, you receive rent; from bonds you receive interest payments; and in the case of shares, you receive a portion of profits in the form of dividends.

“Our belief in the importance of distributions to investors through dividends is based on two simple premises: firstly, it is impossible for the share of the economy taken up by a particular asset to keep rising in perpetuity; secondly, long-term history (100-year history) teaches us that the vast majority of returns come from reinvestment of dividends.

“The case for equities is two-fold: firstly, dividend yields are higher than their bond and property equivalents; secondly, corporate profits – which feed inevitably through to dividends – should grow in line with the economy, and should, therefore, outpace rents and interest payments. Longer-term history suggests both these points are true.

“Dividends in the US have grown at a composite rate of 4.1% over the last 110 years, rather better than inflation over the period. In contrast, the coupon on a bond is fixed – there is no opportunity to benefit from the underlying growth of the economy. Because of this growth, that investors would be expected to pay more for shares. When dividend yields are substantially above 10-year bond rates, as they are now in Europe, one would expect substantial absolute and relative returns for equities.

Valuations

“We can use various methods to measure the relative expensiveness or cheapness of stocks and other assets. We can compare prices to earnings (P/Es), to dividends, to book value, or some even more esoteric measure. Looking across the major markets of western Europe, the US and Japan, we can see that P/Es and dividend yields (based on next year) are at substantial discounts to historic levels. This suggests a period of strong equity performance in the coming years.

“In the period since the First World War, there have been only two occasions when equities have performed as badly in real terms as they have in the last 11 years: in the periods following the great crash of 1929, and in the long 1970s bear market. And when equities perform badly, the fearful flee the market but investors who took the long view and who committed money when others were fearful did extremely well.

“Equities are, over longer periods, geared to the growth of the world economy. And even as valuations and prices have shrunk, the world economy has grown. As China, India and other nations join the cadre of developed countries, the opportunities for growth and for equities are legion. It is said that history never repeats, but it does rhyme; well, the song for shares sounds pretty upbeat right now.”

THS Partners manages funds for St. James’s Place.

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