Thu, 21/09/2006 - 06:58
The current Global Investment Outlook courtesy of Aberdeen Asset Management…
Economic and market outlook
• Global industrial production is now peaking in the short term, with the downturn in momentum led by the US. As a result, the synchronous growth phase of the last year we believe is coming to an end. Inflation however remains a short run threat in several countries, not least those that are less advanced in the interest rate cycle. However, the medium term outlook is still favourable.
• Recent weak housing market data in the US has led some analysts to predict significantly slower growth next year, if not outright recession. Consumption may well slow as households rebuild savings, but the extent of any weakness should be mitigated by continued job creation. We are optimistic that the US experiences a soft landing as opposed to a dramatic retrenchment.
• Recent business surveys in Europe have rolled over, but still point to above trend growth. Consumption remains the key and here the evidence is more mixed. Official retail sales statistics still disappoint despite the World Cup. However, consumption growth in GDP reports is running ahead of retail sales and the unemployment rate fell to 7.8%, equal to the low recorded in 2001. Growth should be healthy this year but weaker in 2007.
• The UK services sector has been a support during the second quarter, along with manufactured exports. Some analysts have pointed to the revival in house prices as a catalyst for a modest recovery in consumption as well. Overall growth may continue above trend for a quarter or so yet, but the housing market has still not returned to its strength of 2004/5 and the external environment may yet impinge upon demand. We continue to expect only trend like growth conditions next year.
• Japan continues its emergence from the mire of the last decade despite recent weaker growth data. A tightening labour market is helping to drive wages higher, as consumer price expectations continue to rise to the highest levels for some time (probably due to distortions from petroleum). Nevertheless, this has boosted domestic demand as has buoyant capital expenditure.
• Chinese data for July points to a sustained pace of activity. A surprising drop in CPI inflation was announced on the back of lower food prices, and some moderation in industrial production and fixed asset investment was witnessed. We expect growth will lose some momentum in 2007.
• Elsewhere in Asia, we believe that activity will suffer a similar fate towards the end of 2006. This downturn is expected to be modest, and not necessarily all encompassing. Countries like Malaysia and Taiwan could repeat the growth seen in 2006 during 2007, but as we indicated above, the situation in the US needs careful monitoring.
• The commodity markets have demonstrated more erratic price movements in recent months, with most prone to selling off aggressively on bad news rather than rallying on good news, potentially indicating a change of sentiment, particularly in the base metals. We believe that demand factors, which have been the main driver of the rise over the last three years, are now waning. Most Chinese metal imports data for example show negative year over year comparisons.
• Inflation remains a risk globally with the combination of higher commodity prices and tighter labour markets. However if the recent reduction in energy prices continues, this should be a comfort to policy makers, reducing the pressure on headline inflation rates thus reducing the chances of inflation expectations galvanizing excessive wage demands. We feel more confident that inflation will remain contained in the medium term.
Bond Yields, Currencies and Monetary Policy
• The August statement from the Federal Reserve asserted that inflation pressures seem likely to moderate reflecting the cumulative effects of monetary policy and other factors on aggregate demand supporting expectations for a continued pause. However, limited spare capacity still biases policy makers to tighten and the chances of a further rate hike in the next quarter are still prevalent. Overall, we expect there to be a fairly prolonged period of policy stability during the next year, and still do not depict this as the end of the tightening cycle.
• UK authorities surprised the market by raising base rates in August. We now feel that they may raise them again before the end of the year, and indeed this is a change to our view. It appears that the MPC are focused on the lack of any substantial output gap. With growth possibly growing above trend in the second half of the year, this may provoke another move. Eventually external factors should soften the outlook restraining this shift upwards.
• In Europe, a normalization of policy is still very much on the cards. Although Trichet has denied there is any pre-determined schedule, another rise in October seems likely. The ECB continue to describe policy as accommodative and real rates as low, suggesting our forecast for rates to reach 3.75% during 2007 as perfectly possible.
• We think that the most likely scenario in Japan is for rates to rise to 1.0% over the next year in a gradual manner. The Bank of Japan has now abandoned the emergency measures of the last decade, and the government are increasingly convinced that victory over deflation has been attained.
• Bond markets have revived from their mid-summer torpor with yields in most ten -ear government markets falling between 0.25% - 0.5%. Yields generally have exhibited a large degree of correlation with equity prices and the recent bout of equity market turmoil paved the way for a correction in the rising yield environment that has prevailed since 2003. With unchanged or rising interest rates, we feel that bonds represent poor value in most cases. This applies equally to index-linked as it does to conventional markets, where we continue to adopt relatively defensive positions.
• As we enter the autumn, we are moderately pessimistic on the outlook for corporate bond markets. The fundamental picture has weakened and the technical outlook is also deteriorating. We have been reducing our positions in expensive industrial credits, switching into financial bonds while maintaining flexibility to add to our risk positions.
• The recent base rate move in the UK has given a bid to sterling in the short term as the market extrapolates out a continued widening in interest rate differentials. Since we feel that further rises will be limited, the pound seems vulnerable to a reverse of this view. The US dollar itself may still be weakened by narrowing differentials with both the Yen and the Euro although this is mostly priced in.
• The longer term outlook for equities we believe remains positive. In the immediate future, there are still concerns surrounding the outlook for growth and profits. The volatility we have witnessed since May could be prevalent for a couple of weeks yet, but we feel we may be approaching the end of this bout of investor risk aversion.
• The relationship between bond yields and equities has become quite interdependent as each has risen and fallen in tandem. Short dated yields are significantly below policy rates, and since central banks still seem biased to tighten, this suggests that investor expectations regarding policy could yet be disappointed. If they are, it is likely to be in the context of a supportive equity environment.
Yield curves are inverted though, which historically has been a presage to slower growth. Markets are therefore at a critical juncture with regard to relative performance between equities and bonds. Traditional measures of relative value between the two suggest that longer term value lies with the former. Indeed, increasing dividend yield and payout ratios should further support stock markets, thus we prefer equities to bonds, but the risks to this view are not insignificant.
• In addition, global PE valuations are undemanding and liquidity within the global financial system is not particularly tight which should bolster stocks.
• We remain relatively cautious on US equities as we feel that consensus expectations surrounding profits growth may not be met. Nevertheless, the overall health of corporations is still good. Within S&P 500 companies, cash balances as a percentage of the value of the index are over 8%, not far below the highs for the last decade. This will undoubtedly support share prices to a certain degree, although we believe a slowing trajectory of profit growth into 2007 may hamper overall returns.
• Despite our continued cautious stance towards the US market, we have recently reduced our underweight position. Sterling based returns for US stocks have been poor this year, in fact producing losses, and we felt it opportune to increase our holdings although we still remain underweight.
Europe (including UK)
• UK companies are enjoying a similar level of financial comfort. As is apparent at a global level, UK companies have been increasing dividends and improving the yield of stocks. Strong share buyback activity is also at extreme levels and when adjusting for this, it has effectively raised the overall yield of the market to something over 5%.
• On the supply front, pension funds continue to be a key source of liquidity in the market, as they have been selling UK equities since 1995 in favour of international exposure, the pace of which has quickened markedly in recent years. We feel that the overall trend of excess supply in the UK market is still there but should dissipate during the next year.
• In Europe, stock selection is becoming increasingly important as the valuation gap with other markets, such as the US, has narrowed. Although this is in part due to relative price performance, it is also true to say that other markets have suffered a bigger de-rating, re-aligning relative valuations. At an individual company level, there is still value to be found, although the obvious opportunities have disappeared.
• Signs of change in Japan are also evident in the corporate world. The gradual demise of the Kiretsu system, and greater focus on shareholder value, has served to heighten the potential for corporate M&A activity. Most important is that the number of hostile bids is rising. So far this year, three hostile deals have been announced with Oji Paper's attempt to acquire Hokuetsu Paper Mills being the most high profile.
• Whether these moves are successful or not, the fact that they have happened is significant, not least given the rational for each is purely financial, a factor which has been lacking in the past. With strong corporate balance sheets and many business sectors which are highly fragmented, the potential for further activity is high, creating a very different dynamic to the market. In sum, we believe that profit growth potential is still considerable.
Global Emerging Markets
• With continued near term uncertainty over global growth and inflation, it is possible that Emerging markets experience further volatility. For certain countries, US demand remains a key factor, but the degree of dependence has lessened in recent years as more astute macroeconomic management has prompted less reliance on external capital.
• Market expectations for earnings growth across the region are strong but valuations are still substantially lower than the developed nations. We would not advocate that emerging companies should be on an equal footing with the developed world in terms of valuation, but we do argue the case for a narrower differential.
• India and China are the two 'vogue' areas of Asia with both countries sharing an extensive opportunity for growth. India offers a number of well-managed companies in several dynamic industries, such as the IT and pharmaceutical sectors, as well as the rapidly growing finance and consumer sectors. We would view the recent sharp retreat in the stock markets as a healthy correction after a prolonged period of out-performance.
• Although plentiful liquidity in China has been a fillip for growth, easy credit conditions have resulted in undisciplined investing. Government-linked companies dominate the domestic stock market and, unlike in India, local subsidiaries of multinationals have not been able to list on the domestic exchange. Consequently, from a quality standpoint, we still prefer to gain exposure from those Chinese firms listed in Hong Kong, where standards of accounting and transparency are better.
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