The current market volatility seems to have created a lot of potential value for eagle-eyed stockpickers. Hugh Yarrow, co-manager of the Rathbone UK Equity Income fund, observes that ‘In the current environment, with growth and momentum still attracting premium ratings, we are focusing on finding those stocks trading at prices below their intrinsic value, often in areas currently out of favour with the market. Our value-oriented investment process remains intact and is centred on companies with strong balance sheets and high cash generation, which allow reinvestment in the business and rising dividend payments.’

He adds, ‘Despite sharing some of the market’s concerns regarding a slowing macroeconomic environment, indiscriminate sell-offs can often unearth interesting opportunities for the long-term investor. In fact, we have used market volatility to add to positions in key holdings where we perceived the market to have overreacted to corporate newsflow. These included Cable & Wireless, Tesco and Restaurant Group.’

Ignoring fundamentals
His colleague, James Thomson, manager of the Rathbone Global Opportunities Fund, feels that ‘Volatile conditions will continue. In the short-term, investors will ignore fundamentals, and be sensitive to newsflow and momentum. We are not tempted to buy very distressed areas of the market, including financials, or succumb to classic defensive positionings in utilities, pharmaceuticals and food producers.’

However, Peter Reid, UK chief investment officer at Resolution Asset Management, feels that UK companies in particular are failing to account for the possibility of a genuine recession. He believes that any such recession would be ‘short and sharp’, but he does not expect the economy to pick up meaningfully for at least 18 months, with the stock market likely to mark time in the near term.

He adds, ‘Although the economy cannot be revived with rate cuts alone, the MPC must be decisive when it does start to act, as inflation fears are overdone. But the consensus is for UK profits to grow seven to eight per cent in 2008 and we don’t think this will be the case, especially given that profit margins are starting from a very high level already. In my view, profit expectations need to come down closer to flat year-on-year to reflect what will be a very difficult environment for firms over the next 18 months or so.’

Reid feels that ‘The financial sector is still a huge negative and we are still working through the liquidity problems. Sovereign funds are helping but financial institutions are still finding it difficult to lend, and this will continue to hit the underlying economy. This simply cannot be fixed by rate cuts alone.’

US still stuttering
The other key question is whether the US is about to plunge into recession? Bob Doll, chief investment officer for Global Equities at BlackRock, reports that ‘In our view, the US economy is still teetering on the edge of, but is not necessarily in, a recession. The rebate checks associated with the stimulus package that Congress passed
this month could jump-start consumer spending in the second and third quarters.’

‘The good news is that it seems most of the bad news is already known, and the stock market has already priced in the likelihood of at least a mild recession. However, we continue to see a great deal of turmoil in credit markets, which has been putting enormous amounts of pressure on financial institutions. All told, we believe the positive factors will keep the US economy, and non-financial corporate profits, at least somewhat intact.

Doll concludes that ‘In our opinion, the overwhelming amount of negative sentiment
in the markets suggests that the preconditions for a market rally will eventually come together. The “positive surprise” that sparks such a rally could be how well the non-financial corporate sector holds up. But we do not believe such a rally will happen before stock prices complete a bottom-testing phase. Such a bottom could mark attractive buying opportunities.’

The resilience of Asia
So with continuing evidence of economic weakness in the developed economies, particularly in the US, attention is focusing ever more strongly on the markets of Asia and on their potential to withstand global economic shocks. Alan Gibbs of JO Hambro Investment Management, manager of the Waverton Asia Pacific Fund, points out that ‘Since the early 1970s, the global economy has operated on the basis of a “fiat” money system, relying on financial companies, central banks and politicians to provide the expansion of liquidity necessary to support the growth of world trade. This system has, arguably, enabled both the developed and the emerging economies to grow
at unprecedented rates. The Asian growth story has been one of highly significant result.’

But, he adds, ‘In recent months, in the aftermath of the August crisis, this system is facing its greatest test. The big question now, for the global economy and for Asia, is if this is just another such instance. My view is that 2008 will be the year when it may become clear that Asia, and other emerging countries, need to play a greater role in this “fiat” money system. To an extent, we can already see this happening as sovereign wealth funds buy into Western financial institutions, and in China’s slow, but significant, acceptance that its currency needs to appreciate against the US dollar. It is vital for Asia that this trend broadens and accelerates.’

Gaining confidence
Gibbs feels that ‘Indeed it shows every sign of happening. The recent “dawn raid” on RTZ by Chinalco, in partnership with Alcoa, is a good indication of how the sophistication, and appetite to participate, is increasing. The main reason is that the financial infrastructure in Asia itself is still very underdeveloped, whether it is in public or private equity markets or in the bond markets, and Asia cannot afford to hold itself hostage to the West if it is to continue to grow at high rates. The current breakdown of normal service in western credit markets highlights this danger.’

He points out, ‘Increasingly in recent years, Asia has supplied liquidity to the grid of the global credit system. So far, there has been no real sign of a serious slowdown in Asia. The Singapore growth rate did fall in the last quarter, mainly due to softness in the pharmaceutical sector, and it would be surprising if other regional export sectors did not follow suit. But the infrastructure sectors across Asia and the Middle East seem likely to remain very strong through 2008. In China, the authorities are still clearly intent on keeping a brake on growth through a combination of raised interest rates, increased reserve requirements and, most important of all, central direction. Despite this, consumption remains very firm and the need to invest in power, rail and road networks would seem to underwrite a strong economy.’

Gibbs asks, ‘What are the implications for investment in the Asian region? Firstly, a new element of uncertainty has been introduced after a number of relatively predictable years. For companies, it is not so clear how available liquidity and funding will be. Most importantly, the current issues in the financial markets highlight the truth that the balance of power and influence is shifting east. Barring serious geopolitical disruption brought on by the credit crisis, portfolio investors are likely to follow. A combination of high growth, volatility, and institutional change should provide a very good entry point for new investors in 2008.’