Thomas Becket, CIO, PSigma Investment Management

Opinion: In the summertime

Thu, 21/07/2011 - 07:00

It could be a long summer, argues PSigma Investment Management chief investment officer Tom Becket (pictured), with the European sovereign debt crisis and the political argument over raising the US government debt ceiling still unresolved. Unless these issues are tackled decisively, not even the sterling performance of the corporate sector may be enough to sustain the fragile market recovery of the past two years…

The last few weeks have been extremely testing for financial markets, once again ruining summer holidays, as fund managers nervously glance at their Blackberries under the disappointed gaze of their families. Recent summers have all proven incredibly nervy for investors and this summer seems set to rival them.

This year we are still dealing with some of the infamous issues of summers previous, amongst them the European debt crisis and the questionable global economic recovery, whilst some fresh issues have also reared their ugly heads, including the untimely arguments over the raising of the debt ceiling in the US.

If that wasn’t enough, we are also currently delving through the deluge of data from one of the most potentially pivotal corporate reporting seasons of the last few years. In isolation any one of these critically-important issues could be enough to distract you from the poolside novel. Together, they could be amounting to a perfect summer storm.

Once again, we must start in Europe. Last month, we described how the European debt situation was fast becoming a farce. Sadly it has now moved beyond even that, as the squall has spread from the peripheral nations of Greece, Ireland and Portugal, to seriously significant countries such as Spain and Italy.

Borrowing costs have risen out of control for Italy and Spain in the last fortnight, predominantly because decisive action was not taken earlier by the European authorities in their handling of the Greek tragedy. Markets are now effectively challenging the European governments to take hugely radical steps to draw a line under the latest crisis within a crisis.

Whether they can do this before a country is forced to default is now highly questionable. Ultimately we believe that the Europeans will have to resort to the printing presses to buy huge swathes of the European bond market. Until then there will be posturing, pointing of fingers and pain aplenty.

Unless we see a short-term solution in the coming weeks, the market recovery of the last two years could be over and a material correction could ensue, particularly if a country is forced to default. We are far from convinced that the financial sector is in a position to deal with the fall-out from a default, despite what the Panglossian politicians might suggest after recent banking stress-test results were revealed.

The easiest way to solve the structural debt issues that are acting as an anchor on the global economy is to generate growth. Growth spurs tax revenues, reduces dependency on the state through increased employment and buoys confidence. It is therefore very unhelpful that just as the debt fears have escalated, the global economic engine has spluttered again.

Most commentators, ourselves included, believe that we are experiencing a mid-cycle ‘soft patch’, but recent data points from around the world (with the notable exception of the seemingly rampant China), have forced us to re-think how ‘soft’ this period might be and how long a ‘patch’ could last.

In fact, we are now debating whether we are witnessing the start of the new economic cycle, which would see growth slow further. Given the persistent weakness in consumer confidence and reluctance amongst corporate managements to spend their hard-saved cash piles, any renewed slump would leave equity and credit markets vulnerable. We will watch the economic data releases over the next few weeks with trepidation.

Debt is also at the forefront of the immediate issues in the US, although for now it is for a very different reason than across the Atlantic. While the US shares many of the factors that has pushed the European bond markets to the brink, the present problem there is the political horse-trading over whether the US should raise their limit of the debt that they are allowed to issue.

If the Obama administration and Democrat party is permitted to add to the swollen debt volcano, the Republicans want to try to score as many political points as possible in their agreement. President Obama has appeared increasingly desperate in his marshalling of the debate and consumer confidence in the US has slumped to levels last seen in the recession of 2009. Weak employment data has also added to the grim air hanging over the US consumer.

In theory, were the US politicians not to come to a hard-fought union before August 2, the US is scheduled to run out of money and could default on its debt. This is what the credit rating agencies have been suggesting in recent weeks, adding to the fires of uncertainty that have been burning.

Whilst we do not believe the US politicians are stupid enough to fail to break the impasse, we have to acknowledge that this is a graphic illustration of the potential for politicians to endanger the fragile state of the global economy (sadly, with a presidential election brewing in the US in 2012, it is only likely to get worse). A resolution in the US, as well as in Europe, is needed fast.

Where we remain confident is with the corporate sector. Companies are continuing to demonstrate a reassuring ability to generate robust profits growth, through steadily increasing sales and strict control over their costs. Obviously, commodity prices have the ability to derail that happy scenario by squeezing margins, so we are watching the impact that a strong oil price and other commodities might have had in the second quarter.

It would also be naive to believe that sales growth could continue were the economy to relapse into recession, but for now we believe we can find sufficient cause to maintain a neutral weighting in equities. With equities inexpensive, as long as recession does not eventuate, we shall hold that position unless we feel that one of the dangers described above really is about to create chaos in markets.

Mungo Jerry sang in In the Summertime that “we’re always happy as long as we’re living in this sound philosophy”. We hope that the soundness of corporate balance sheets, the improving trend of M&A and continued dividend growth will at least be partially able to offset macroeconomic concerns. If the big economic woes do abate later in the summer, there is still a fair chance that equity markets can finish the year with the flurry that the companies’ resilience deserves.

Elsewhere in asset markets, we have uncharacteristically low levels of conviction. Our favoured investments of the last few years, high-yield credit and index-linked bonds, now look stretched and we have pared back positions in these asset classes over the last few months. Government bonds look outright expensive, unless you think the world is truly about to collapse in to the abyss.

Commodities have been superb performers over the last few years, but with investor interest and actual prices still high, we are struggling to get overly excited about the near-term outlook. Commercial property looks dull to us, as yields are too low to compensate for a possible fall in capital values. Having been very active in our asset allocation over the last three years, our tactical decisions are now being driven by whether we want to either increase or decrease equity risk.

Compounding the problems in markets has been liquidity, as trading volumes are extremely thin, which is adding to the wild swings in indices. It has become quite clear that investors are unwilling to make brave new bets whilst the stresses in global bond markets are still unresolved. This seems sensible to us as well, although we remain ready to act decisively, as we hopefully get more clarity in Europe and the economic clouds clear. It could be a long summer.
 


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