| Monday, 08 August 2011 13:17 |
Special Market Bulletin – Monday 8 August 2011Introduction In 2008 investors experienced stock market volatility caused by:
Writing today, with more than a hint of déjà-vu, world markets have again fallen sharply, with this time, the reasons for the fall being:
the well-publicised Sovereign credit crisis affecting the Eurozone and worries that, despite resolving its immediate borrowing problems, the US may yet fall back into recession.
In many ways then, the issues that the markets are worried about today are not entirely new and have been known about for some time. However, on Friday evening, after the markets had closed for the weekend, something new did happen. For the first time in its history, the US lost its AAA credit rating as Standard & Poor’s downgraded it one notch to AA+.
This note explains what has happened in both the US and in the Eurozone and what we believe this is likely to mean for investors, both in the short term and after the dust has settled.
In its leader column at the weekend, the Financial Times stated that “If one good thing comes out of this week’s market panic, it would be to shock politicians out of the complacent parochialism in which they sought refuge before the danger was over. Things are still not as bad as 2008.”
We agree. We also believe that now is not the time for investors to panic and we explain how markets behave in times of crisis and having analysed the performance of the FTSE 100 index, why this is not the time for investors to sell equities.
US downgrade
The decision to downgrade the US taken by Standard & Poor’s on Friday was, in their words, as much a judgement about the political leadership in the US, and in particular their willingness to put political differences above seeking a solution to their self-imposed debt ceiling, as it was about the fact that they regard the proposed solution as no more than a temporary fix to America’s debt dependence.
However, their decision was not followed by the other two major debt rating agencies, Moodys and Fitch, both of whom confirmed they will maintain their AAA ratings for the US. To this extent, whilst the short term result is likely to see markets unsettled, indeed they have fallen by between 2% and 4% in the Far East this morning, and the UK is down c1.5% in early trading, it may not actually be a significant move. Asked about whether the US deserved to be downgraded, Warren Buffet speaking over the weekend gave an unequivocal answer. “No”. Indeed, one of the consequences of the continued volatility has been a further reduction in US bond yields as investors seek the safety of US Treasuries!
He pointed out that there is no question of the US defaulting on its debt, nor is there any question of its ability to repay it. In fact, he went on to say, “if there was a quadruple A rating, we would give it to the US”.
Following the downgrade though, there are now just five countries in the G20 which have a AAA rating: France, the UK, Germany, Australia and Canada. Even after its downgrade, the US remains the next most highly rated of the G20 countries.
The other point investors should take note of is that, despite the protests from countries like China and Russia, who understandably are concerned that their holdings of US Treasury Bonds should not fall in value, they are unlikely to abandon the US as it remains one of their largest export markets and their purchases of US dollars helps to prevent their own currencies from appreciating too much against the dollar and thereby making their exports more expensive.
US debt ceiling
The uncertainty regarding the US debt ceiling that we saw last week has moved from the economic stage to the political.
The legislation will cut spending by up to $2.4 trillion over 10 years and raise the debt ceiling by $2.1 trillion until 2013.
As The Financial Times noted last week, even full implementation of the savings will only account for just over 1% of projected gross domestic product over the decade, and falls short of the minimum $4 trillion in deficit reduction that most budget analysts say will be necessary to stabilise long term debt levels.
However, since signing the deal to allow the new debt ceiling to come into effect, US economic data continues to be weak, so much so that doubts remain about the strength and sustainability of any economic recovery, despite better than expected US payroll data on Friday.
Given the action taken by Standard & Poor’s, a more robust solution to the US debt problem is now more likely to be found and further measures to support economic growth – which, when they come will provide support to US companies and hence the US stock market – are likely to be needed.
Eurozone worries
As well as the US, last week also saw politicians in Europe trying to formulate fresh responses to their own debt crisis, as investor support for Spanish and Italian bonds fell away sharply. The lack of support saw yields rise to 6.45% and 6.25% respectively, close to the levels that pushed Greece, Ireland and Portugal into EU-funded bail-outs.
Initially, markets believed that the European Central Bank (ECB) would step in to support European bond markets. What transpired though was limited support for Ireland and Greece but no support for Italian and Spanish bonds, a move which shocked and surprised investors. This triggered a fall in investor confidence and the re-emergence of concerns about the political will to find a permanent solution to the Eurozone’s problems.
Over the weekend it seems that the decision has now been taken to allow the ECB to support Spain and Italy, and already this morning yields on these countries’ bonds have fallen below 6%, signifying greater investor confidence in the Eurozone’s willingness to provide support. It does though, beg the question as to whether this now means we will see the ECB take on a more proactive stance and even issue Eurobonds and stand decisively behind the EU member states. Such a move is, for the EU, as much about political change as dealing with the deficit is to the US.
The summer holiday effect
While all this is going on, just about everyone in government is on holiday, with few showing any signs of rushing back to work. In fact, August is a very quiet period for stock markets, with, typically much lower volumes of shares traded than during other times of the year. Because of this, price movements (up and down) are often exaggerated - as we have seen over the last week or so.
The graph below illustrates this for the UK market and also shows how trading has been reducing in recent times.
Source: Bloomberg
The impact of market movements
Not all stocks are equally impacted by market falls. As the graph below shows, there are still sectors of the UK stock market that have made positive returns for the year even allowing for the recent market downturn. The three sectors with the greatest weighting within the index, Basic Materials, Financials and Oil and Gas, which together account for over 52% of the index, have been the biggest fallers.
Source: Financial Express to 4 Aug 2011
What this illustrates is the importance of looking beyond the headline numbers, the performance of the index, and focus on the underlying individual companies. Most companies have the same business today as they had last week and last year. They have not, suddenly, become poor businesses overnight. Establishing their true value at a time of market volatility is a matter of fine judgement, but lies at the heart of successful investing.
As an example of just how well companies are performing, The Wall Street Journal reported on Friday that around 80% of the S&P 500 companies had reported quarterly earnings better than expected with the average outperformance being around 4%. This is nearly double the average number of outperforming companies when compared to the average measured over the last 25 years. Corporate cash levels are at record levels, enabling companies to afford significant dividend increases and/or increase share buy-backs.
Typical examples include Apple, with $76 billion in cash, General Electric, trading at 12 times earnings, and IBM at 13 times, both comparing favourably to the S&P long term average of 16.
In the UK the dividend yield on the FTSE All Share is 3.7% net of basic rate tax, and has risen by 19% in the first half of 2011. This contrasts sharply with the yield on 10 year Government Bonds of just 2.7%, a ratio of 1.4. Unusual as, for most of the last 50 years, the ratio has been less than 1, suggesting that UK equities are very good value compared to gilts. A view shared by the SJP fund managers represented here by Cato Stonex of THSP and Neil Woodford of Invesco Perpetual.
Speaking last week, Cato Stonex of Taube Hodson Stonex Partners and Fund Manager of the St. James’s Place THSP Managed fund said: “It remains the case that equities are extremely cheap. We believe that this value is exceptional and provides a rare opportunity for investments in very solid companies, which offer significant upside once sentiment improves.”
This was echoed by Neil Woodford of Invesco Perpetual and Fund Manager of the St. James’s Place Invesco Perpetual Managed fund: “We believe the current returns on offer from UK equities look very attractive. In our view, there currently exists an unusual opportunity to invest in such companies, representing some of the biggest and best businesses, at valuations which do not appear to reflect the quality characteristics that they offer.”
What should investors do?
When markets are driven by sentiment and prices are volatile, all investors show concern, irrespective of whether it is in relation to a new investment or an existing one. Not all investors have the patience, or the confidence, to follow Buffet’s words of wisdom and, “be fearful when others are greedy, but be greedy when others are fearful”. But, buying equities when markets are weak, and not panicking when they fall, is sound investment advice.
Understandably, when markets fall sharply, investors are concerned about the value of their portfolio and don’t like to see ‘losses’ being incurred. However, our advice has always been; don’t panic, don’t sell when prices are falling and, if at all possible, avoid being a forced seller. It is far better to remain invested through periods of market volatility. The reality is that markets rise on more days than they fall and, over time, a well-managed portfolio will make profits.
The graph below shows the daily price movements for the FTSE 100 index since the beginning of the millennium, 1 January 2000. As you can see, there are as many ‘up days’ as ‘down days’ and the size of movements are not dissimilar, although up days tend to exceed the down days.
It is worth noting this period includes both the bursting of the 1999/2000 technology bubble and the events seen in 2007/8. Figures from Fidelity show that someone invested in the FTSE All-Share Index over the past 15 years would have seen returns of 168% or 6.8% p.a. However, if they had panicked, sold and missed just the 10 best days performance, their returns would have shrunk to 45% or 2.5% p.a. Market volatility is something that is always with us.
Despite the current uncertainty, investors can use the many, many lessons from history to support and inform their strategy. A portfolio that is well diversified across different asset classes has over time, proven to be the right strategy for investors to reduce risk and achieve their investment goals.
Diversification is a simple concept, yet it remains the single greatest factor in determining long term investment returns. No one can predict which investment or asset class is going to produce the best returns month after month or year after year, but there are two things we can be sure of:
The best performing investment in one year will often turn out to be a poorer performing investment next year. By spreading money across a selection of asset types, countries and sectors, investors give themselves the best chance of achieving consistent returns over time.
The importance of diversification and the inability to successfully time market movements consistently, month in, month out, is the basis behind the new range of St. James’s Place portfolios which were constructed following the last financial crisis of 2008/09, and have been designed to provide an appropriate mix of funds to achieve diversification with different levels of risk. Whilst no portfolio solution can eliminate all investment risk, these are designed to provide solutions for different investment objectives across a range of risk profiles.
As a simple illustration, it is interesting to see how they St. James’s Place Investment Grade Corporate Bond and Commercial Property funds have performed this year, in comparison to equity markets.
Source: Financial Express 2010. year to date to 8 August 2011. All figures are percentage growth on a bid to bid basis for accumulation units, income reinvested and in fund currency. Please be aware that past performance is not indicative of future performance
Unsurprisingly – to us, this performance is in marked contract to the fears expressed earlier this year of rising interest rates and inflation, which caused many investors to dump bonds and property in favour of equities.
As explained, in the current volatile conditions, there will be many companies and sectors trading at valuations which will prove to be very attractive, especially when judged on a medium to long term time horizon. Market falls are a fairly regular interruption to the general upward market enabling investors with a long term horizon to benefit from the opportunities they present.
One immediate consequence of the current conditions is that the record low levels of interest rates seen in the UK and US are likely to be here for some time. Roger Bootle at Capital Economics who accurately forecasted the lengthy period of low rates we now have, updated his forecast last week to state that he believes rates will remain low until 2013 or 2014.
Against this background, returns for equities, corporate bonds and other asset classes will do well – even if there are bumps along the way.
And, of course, investors can take advantage by ‘drip feeding’ future investments into markets over a period.
Conclusion
When we wrote about the events in 2008 we ended by reminding investors that if their investment objectives remained the same, then they should focus on this and remain invested. The worst thing to do would be to panic and try and sell into a weak or falling market. That advice was – as we expected – proved right and it remains the right advice today. 129 views
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