Commentary – Quarterly Bulletin, July 2009

28 July 2009

The strong recovery in the prices of higher risk assets over recent months has been a function of positive developments which have virtually eliminated the possibility of a slide into global financial meltdown and economic depression. The various government support packages for the financial sector, including low interest rates, have helped to stabilise the overall economy and some of the data has been suggestive that the bottom of the cycle may be at hand. We should not, however, lose sight of the fact that GDP is still falling in most countries and structural imbalances, now including massive public sector deficits, are likely to impede the economic recovery when it does come and may even shift the global growth trend onto a lower slope for several cycles.

Equity markets have moved quickly to reflect the improved outlook.

(Perhaps too quickly) Some equity markets rose by over 50% from their respective lows in a relatively short space of time. Towards the end of the second quarter these rises were partially reversed as doubts begin to emerge about the timing of the recovery. This is not unusual after such a dramatic change in price levels and we may once again be moving back into a period of higher volatility, although not on the same scale as we saw last year. In my view, it is unlikely that equity markets will revisit their low points reached earlier this year and long-term investors who have cash ready for investment should now be looking for opportunities to do so during periods when markets are in retreat.

The financial sector of the equity market has been outperforming again during the recent run-up even though many financial companies are still in serious trouble.

The point is that the risk of financial meltdown has been significantly reduced and investors are prepared to value these companies as having a viable future again. It is interesting to note that in both the UK and US markets the financial sector is now back at about the same level (measured by total return indices) as it was at before the financial boom got underway in the early-1990s. This is illustrated in the first chart. Note that the interruption to the financials boom in the late-1990s was due to the even bigger boom in the technology sector. We can be sure that one of the consequences of the financial crisis will be a heavier hand on the regulatory tiller. Banks, in particular, are unlikely to be allowed to expand their activities as freely as before and will probably need to hold more capital reserves which will restrict their ability to grow their earnings. This could well lead to a prolonged period of underperformance for the sector.

In coming quarters, investor sentiment will be pulled to and fro by expectations for the timing and strength of the economic recovery.

There has been much debate about its likely ‘shape’ with various letters of the alphabet such as V, W or L being touted as possibilities. More recently some more imaginative observers have suggested that a square root sign or even the shape of a saxophone may be more likely! Given that economic growth data is revised many times, and for some time, after the initial reports, these debates are of more interest to short-term traders than long-term investors. The trend of economic growth and inflation over the next few cycles will be of greater consequence for investment performance in the medium to long-term.

In the long run, earnings and dividend growth are the main factors that drive the trend in equity price performance.

But the change in valuation of these factors, from the date of purchase to the date of sale, can either enhance or reduce the actual return as compared with trend performance. After such a prolonged period of poor equity performance it may be tempting to think that equities are no longer the vehicle to deliver investment growth. The second chart, however, shows that while equity price performance has been flat for the past 10 years, earnings have continued to rise and would need to halve from now to close this gap. There is, therefore, a good comfort margin to allow for earnings to fall further without necessarily causing prices to weaken. More importantly, looking to the long-term, investing at current levels should enable investors to reap the rewards as the gap is closed by rising prices.