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September 1, 2008

It’s All Right For Some

By Spear's

The past three months have been extraordinarily challenging for equity and bond investors — more so, I must say, than I expected. Not only are several Western markets approaching declines that would formally classify them as bear markets, but the range of share-price catastrophes (stocks that have fallen by more than 30 per cent) covers about one third of the large company indices in the US, Europe and the UK.

The West is not alone. In Japan, the Nikkei fell for a twelfth straight day in mid-July, the longest stretch of losses in more than 50 years — an ironic position for the world’s most energy-efficient major economy. In the energy-consuming emerging world, meanwhile, Indian and Chinese markets have seen year-to-date declines of 35 and 45 per cent respectively.

Indeed, bad news appears to be coming from every corner. Even so-called ‘defensives’ seem to fail day by day — as I write, British Petroleum is locked in a legal battle with its Russian partners (the share price today at 557p is the same as it was nearly four years ago, when oil was priced at US$54 per barrel). Marks & Spencer, a supposed bellwether defensive, is apparently mulling a dividend cut, while Britain’s largest buy-to-let mortgage lender and most of its traditional shareholders have been left high and dry by a single US private equity group that withdrew a promise of £179 million of equity capital — another Northern Rock? In the US, even Freddie Mac and Fannie Mae has had to be propped up by legislation to avert a slide in confidence.

Can a focused equity strategy still combine both ‘protection and opportunity’ in the way it aimed to do over the past twelve months? Certainly, the first few weeks of July started to feel like a perfect economic storm. It started with a US housing crisis and related sub-prime collapse, which forced the Federal Reserve to cut rates and flood the system with liquidity to save Bear Stearns and the US banking system.

This pushed the dollar down and exacerbated a commodity boom that was already threatening global growth. Through the ‘soft dollar peg’ this US monetary policy has been transmitted to the emerging world, and in conjunction with surging food and energy prices — which typically make up more than 50 per cent of local inflation baskets — has allowed consumer prices to surge. Inflation in China remained near a twelve-year high of 8.7 percent in May, prices in Vietnam jumped 27 per cent in June and Indian wholesale prices increased 11.6 per cent in July, the fastest in thirteen years. All of the emerging world and much of Asia are operating with negative interest rates.

The market is now looking for a broader global slowdown, large enough to reduce demand for metals and energy, and even potentially for Chinese and Asian exports. Hence the recent ‘rolling over’ of commodity prices, commodity stocks and Western energy infrastructure plays.

But although this suggests market rotation, it does not necessarily mean a further market collapse. Valuations in the ‘non-commodity linked’ world are exceptionally cheap — European large companies now yield more than bonds, while many UK and European banks are trading at less than 70 per cent of book value (a classic rallying point in the recession of the early 1990s). In the US, you have to go back to the mid-1960s to find interest payments as a proportion of company cash flow at lower levels than today — American exporters are still in rude health. A similar message, surprisingly, is coming from corporate bonds — Moody’s latest report shows a European default rate still near a multi-year low of 0.7 per cent of all issuers.

So how should investors react? Firstly, we are beginning to see value in the Tier 1 capital issues from the larger European banks, in particular those that have largely completed fund raisings and have limited ongoing real-estate exposure.

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We continue to think that the Bank of England will be prepared to accept, for the short term at least, inflation above target if it means limiting the pace of decline of UK housing. Under this scenario, the sterling is at risk.

Though this is not our base case — we will likely see oil and, indeed commodity prices ‘rolling over’ — the effects of an intense hurricane season in the Gulf of Mexico, Israel attacking Iran or terrorists disrupting oil production in Nigeria, Angola and Iraq would be material.

Energy intensity per unit of GDP in China and India is twice the European average, while gasoline prices, despite the latest rollback of subsidies, are still 40 to 50 per cent below the world average. Despite recent market falls, we are still concerned about corporate profitability and tighter central bank policy.

So, within equities, our thematic strategies are taking us toward valuation and restructuring opportunities in global pharmaceuticals and telecoms, while also retaining some core material/energy assets, albeit with considerably reduced market exposure.

In summary, over the next twelve months, world growth will likely slow — but this does not mean recession — and inflation will rise, materially in the emerging world and modestly in the West. This sort of inflationary backdrop has not traditionally hurt long-term equity returns.

Indeed, the relative performance of our thematic global equity accounts shows the sort of opportunities for active managers as pricing power returns to selected companies. We will, therefore, tend to be more a buyer of equities on valuation grounds, rather than a seller of future earnings risk — much of which appears well-discounted in today’s prices.

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