There is currently an increasing level of concern about the macroeconomic outlook, which is rational given that the punch bowl will eventually be withdrawn. The biggest danger now is that fiscal and monetary authorities undermine their own credibilty by morphing the case for “extreme and exceptional measures” introduced to control a banking crisis into a vain attempt to control the economic cycle. If this is attempted it is doomed to failure. The natural order of weak to strong hands will continue regardless and any indecision will result in a repricing of the long bond and a very rapid end to the recovery. To meet a pile of debt with more debt will result in an overall increase in the cost of that debt which is the economics of the madhouse.
The process of deleveraging will continue – it is part of the process of taking money from the weak (leveraged buyers of commercial property) to the strong (cash rich property investors); the transaction liquidates credit but does not destroy the asset value.
In aggregate, equities as measured by either price to book price to sales or price to earnings are not expensive but we face the reverse of the situation at the start of the previous decade with emerging markets priced for earnings growth to continue on a secular basis and developed markets cheap in relation to expectations. Given the likely new era of thrift that the western world faces, the valuation may well reflect reality. However, in both cases more volatility is guaranteed as further rerating of the P as opposed to the E in the PE multiple is unlikely given the relative macroeconomic noise of the next 12 months. The best relative opportunity is in a combination of stodge – the best relative value and the likes of technology – beneficiaries of even a vague pick up in corporate capex from a 30 year low.
In this context, equity fund managers are progressively taking risk off the table from emerging through to developed markets. All share a common objective to find the strong balance sheet, the strong free cashflow, the beneficiaries of the flight to thrift or the consolidator. Small caps must be niche or thriving, large caps stable and profitable. It may be wise to retain the bias to managers that stress dividends or market dominance.
The bubble echo of commodities continues with the “China going it alone” theme supporting the story. The current story looks very shaky with inventories piling higher and commodity stocks (ex oil) moving to expensive levels. The fact that on a price to sales basis many of the pure, as opposed to diversified, mining stocks have returned to July 2007 levels says much about the current price of the category. The energy complex is least exposed to the accusation that it is expensive.
Credit is looking increasingly tired – it’s an income story now. Parts of investment grade are plain expensive. The higher yield space should balance an attractive yield against further corporate distress.
The biggest threat remains a serious and sustained move higher in sovereign bond yields globally, which is dismissed by the deflationists but shows a lack of understanding about the supply dynamics. The best possible outcome would be politicians at least giving the appearance of caring about the deficit while the monetary authorities adopt a soft exit to Quantitative Easing – probably by suspending their own purchases by guaranteeing low interest rates to let the banks ride the yield curve.
We still suspect risk markets can make progress over the year but that volatility will be a constant feature.
By Peter Toogood