What Investment looks at the key issues that are driving the investment decisions of analysts and fund managers.

The decision by the Bank of England’s Monetary Policy Committee (MPC) not to call upon the final £25 billion set aside for ‘quantitative easing’ (QE) at the beginning of July certainly wrong-footed the stock market, although it did give sterling a short-term boost. However, Ted Scott, director of UK Strategy at F&C Investments, argues that the MPC did the right thing.

‘I think the Committee is right to hang fire,’ Scott argues. ‘The jury is out as to whether QE will succeed in its desired objectives but there is also a danger that, by being too aggressive too soon, this will result in raised inflationary expectations. If inflation takes off once the economy starts recovering, it is a dragon that is very difficult to slay, as the UK economy learnt in the 1970s and 80s. A balanced approach is correct for the time being, and the MPC should concentrate on finding a way of persuading, or coercing, the banks to lend in the meantime.’

A watching brief
Ian Kernohan, economist at RLAM, feels that ‘The August Inflation Report will provide a new opportunity to consider the economic outlook and to decide whether further intervention is necessary. The problem will be how to exit the QE strategy, without causing a significant backup in yields and, therefore, increasing the cost of funding the government’s deficit. The gilt market sold off post the announcement, which gives some indication of the size of the QE premium in gilt prices.’

Evercore Pan-Asset’s John Redwood asserts that ‘In the UK, the big issue is how the government gets out of quantitative easing. Prior to its meeting, many market participants expected the MPC to say they were going to spend the remaining £25 billion. They probably came to this conclusion because money growth is currently slowing down a bit, and bank credit is still tight for the private sector.’

He argues that the Committee has, in fact, taken the prudent option. ‘The MPC decided to say nothing firm, leaving their options open. There may be divided opinions on the MPC about the issue. There will be general doubt about whether it is working and how much it takes. They will now be able to see how markets respond to a slower rate of spend and to the possibility of no more easing, without having burned their boats.’

Government intervention
Redwood observes that ‘What also seems to have been happening is a switch of new bank lending from advances to the private sector, to paying for the government’s deficit and bond purchases. Where the government buys the bonds from the UK private sector, that frees some cash for the private sector to spend or to buy other assets such as shares.’

He concludes that ‘If the purchasing is from foreigners, it may do the same, or it may lead to weaker sterling if the foreign gilt owner sells the currency as well as the bond. The government may be relaxed about that, as devaluation appears to be part of the strategy to try to curb the balance of payments deficit.’

Certainly, those in the frontline of corporate financing seem to think that lending conditions are starting to improve. EuroFinance, a subsidiary of the Economist Group that focuses on the corporate treasury sector, reports that, according to its latest quarterly survey of the outlook of corporate treasurers across more than 150 multinational corporations, there is a discernable ‘thaw’ in the frozen credit markets.

Fifty-six per cent of treasurers believe that banks are delivering acceptable lending terms to healthy companies (up from 32 per cent in the previous quarter’s poll), while nearly two-thirds of respondents reported that credit conditions have improved or stayed the same so far this year. More than half of treasurers are comfortable with their companies’ cash flow forecasts for at least six months into the future, yet another sign that conditions are stabilising.

A turning point?
As Carolyn Meier, managing director of EuroFinance, points out, ‘Coming from the primary managers of companies’ cash and caretakers of banking relationships, this could mark an important turning point in the credit cycle.’

But she also warns that ‘Even if these improvements are sustained, it will take time before the cost and availability of credit returns to anything approaching normal, as we once knew it. Indeed, nearly 60 per cent of treasurers do not expect the banking system to fully recover until the second half of 2010, at the earliest. While any signs of “green shoots” are welcome, it is too early to celebrate a blossoming recovery just yet.’

And any hopes that looser credit markets and more optimistic treasurers will translate into a new M&A boom are possibly premature. The survey reveals that the bulk of treasurers do not expect dealmaking activity to pick up until next year, with nearly half of respondents expecting an M&A revival in the second half of 2010 or later. Over the next year, treasurers say that their companies’ focus will be inward – 70 per cent of respondents say that their firms’ primary use of cash will be to reinvest in their businesses or pay down debt.

Jumping the gun
Indeed, the consensus view is that the dramatic market rises that characterised most markets in the spring were a case of too much too soon. Rupert Robinson, CEO of Schroders Private Bank, argues that ‘We are in a corrective phase for equities or, more realistically, a pause for breath as investors digest recent gains and the reality that any economic recovery will be anaemic at best.’

He argues, ‘The fact is that we have travelled too far too quickly and the correction will last until autumn. As happened on the way up, when the rally from March lows to June highs meant everything rose with the tide, we expect all sectors to fall with the tide. This will, itself, exaggerate falls.’

Robinson suggests that ‘We won’t see markets tumble as low as they did in March, but they could easily fall another ten per cent from current levels. We are already five per cent off the highs in the US, Japan and Hong Kong, and seven per cent in the UK and ten per cent in Germany. Bond values will move up, lowering bond yields, and risk-aversion assets, such as the dollar and yen, will strengthen.  Commodity prices will reduce.

‘This is not entirely a gloomy outlook. These lower stock prices will set us up for a good rebound in the autumn through to spring 2010, as monetary stimuli gradually feed through into the real economy and investors become more confident about the earnings outlook and a willingness to look over the valley as the fog lifts.’

Pausing for breath
The broad message is that any recovery will be slow and uncertain, despite the mini-boom that stock markets experienced in the spring. Tom Becket, head of global investment strategy at PSigma Investment Management, observes that ‘After two and a half months of misery at the start of the year, followed by two and a half months of near euphoria, financial markets limped into the end of the first half of the year, seemingly exhausted by a period of overexcitement.’

He points out that ‘Having set multi-year lows in February and March, developed world equity markets delivered one of the best short-term performance periods in history, emerging market equities and bonds gained by a record amount, the oil price doubled from its February low and corporate bonds gained powerfully.’

But Becket suggests that ‘Most markets now seem to be in a state of limbo or “no-man’s land”, as battle-weary investors and traders retreat for the summer break. And while macroeconomic data seems to have stabilised at a low level, there are as yet very few real “green shoots” in the form of actual economic expansion. Confidence, of all forms, has certainly improved over the past few months, although we would suggest that the quick change from over-pessimism to over-optimism is perhaps slightly premature.’

He concludes that ‘The pattern of markets trading sideways is possible for the summer months, as everyone waits to see whether the tentative signs of stabilisation suggest an imminent and sustainable recovery or whether what we are currently seeing is merely a classic inventory restocking cycle. It remains impossible to tell how the global economy will perform in the quarters ahead, although we have lingering concerns about the potential potency of consumer and corporate demand, as the world’s citizens and companies repair their battered balance sheets, following the extreme wealth destruction of the past two years, and as unemployment continues to rise.’

Long-term recovery
Becket reports, ‘We are still investing with two main themes in our portfolios – long-term recovery assets and real growth areas. The former type can include a number of different investments, and currently we have large positions in corporate credit and equities that we believe have been treated unfairly. In addition, we have also recently started to buy convertible bonds, which offer an attractive yield and lower risk participation in equity markets.’

He adds, ‘In terms of our regional preferences, we remain neutral on US equities, overweight in emerging markets and underweight Europe. We believe that the recession in Europe will drag on for longer than in other parts of the world, as the policy response has been limited and there remains no concerted or consistent approach to dealing with the region’s woes. One market about which we have become more optimistic is Japan, where the potential for political change and structural reform is increasing. In addition, Japanese stocks are unloved and under-owned and should theoretically be geared into any global economic recovery.’ 

Emerging growth
What seems to be increasingly clear, however, is that when recovery does come, it will be largely driven by the emerging market economies. Henderson Global Investors’ chief economist, Simon Ward, reports that ‘A strong acceleration in global real money supply growth in late 2008 suggested that economic activity would bottom in spring 2009 and recover during the second half, and recent news remains consistent with this scenario.’

He adds, ‘But the big story of the first half has been the rebound in emerging economies. Industrial output in seven large emerging economies, the BRICs plus Korea, Taiwan and Mexico, rose by three per cent in the six months to May versus an 11 per cent contraction in the G7, and surveys indicate further acceleration.’

Ward insists that ‘This “E7” pick-up is not just about China. Output is on a rising trend in five of the seven economies, the exceptions being Mexico, which will benefit from a US recovery, and Russia. This reflects a rebound in world trade and effective monetary stimulus in economies where banking systems are still functioning normally.’

However, he cautions, ‘There are two key risks. First, labour market deterioration could lead to a further lurch downwards in consumer spending, aborting the stocks-led industrial recovery. Secondly, real money growth could slow as weak credit trends offset QE and higher commodity prices lift inflation. This is less of a concern in the US and the UK than in the eurozone, where money supply (M3) is stagnant and the effectiveness of the ECB’s QE alternative is in doubt.’