All investors are taught early in their careers that the two dominant emotions in financial markets are fear and greed.
Cold rational analysis of facts is all well and good but when emotion takes hold it over-rides everything else; to paraphrase one of the most important adages, JM Keynes preached that the markets can remain irrational longer than anyone can remain solvent.
It is also a truism though that every scare story that has ever spooked markets has been highly credible at the time.
Whatever story it is that is driving sentiment has to be based in reality. Like a good horror film, the greatest terror comes from what is unseen, unsaid and implied. The markets have not recovered from the trauma of the 2007-2009 crisis and still carry the baggage of that great banking disaster. This has become their Achilles Heel and any mention or suggestion that we are heading to another banking meltdown triggers hyperventilation and a panic attack.
The summer months have seen global markets of all descriptions running scared by Europe. The argument is terribly and deceptively simple: the debt can has been kicked down the street for too long and a number of European countries can no longer meet their obligations.
Defaults on sovereign debts, it is argued, are inevitable and will lead to losses on these bonds, the majority of which are held by European financial institutions. These losses in turn will lead to bank insolvencies as national governments can no longer afford to fund further bail outs, the banking and insurance system will collapse and the world will again run out of money. This, so the theory runs, will result ultimately
in the breakdown of civil order.
If we ignore for a moment the more extreme elements of this, the early stages of the argument are highly credible and soundly based on facts. The extraordinary additional factor is that although there are any number of potential solutions to the problem, all these seem to be excluded by the inability of European politicians and bureaucrats to agree on which day of the week it is, let alone a restructuring of Greece’s debts. We have already seen one bank, Dexia, requiring State support from France and Belgium as a result of the protracted political machinations but even the writing of another cheque for hundreds of billions of euros does not appear to be sufficient incentive to come to any conclusions.
It would be wrong to chide only Europe for a lack of leadership. In the UK the Coalition government is riddled with contradictions and internal dissent. In the United States the unseemly squabble in the summer over the raising of the debt ceiling highlighted not only the parlous state of the finances of the world’s largest economy but also that Obama is a lame duck president limping towards election
year in 2012. Japan has had yet another change of Prime Minister with Yoshihiko Noda taking over from Naoto Kan after the latter’s 15 months in office. Noda is Japan’s ninth Prime Minister since 2000 and the third this decade. It is another investment adage that markets hate uncertainty; regrettably this uncertainty has become institutionalized across the developed world.
The cloudy environment is not without a silver lining. In the first instance there is no need for the worries about the development of Europe to turn into reality. The issues are solvable. Second, it is only times of market distress that uncover irrational value. Calm markets tend to value assets highly efficiently; when emotion takes over assets become mispriced. It is now commonplace to see the equity dividend yield of good companies being higher than the yields available on its bonds. This implies that the market is expecting global dividend growth to be zero and possibly negative over a period of many years, a scenario that is massively too pessimistic in anything other than Armageddon. For the long term investor prepared to be both sensible and patient, the returns offered by a good number of quality equities have rarely been better.
Markets have also tended to forget that there is a world outside Europe. Economic data is indicating that the United States has suffered another lull, albeit one rather sharper than in 2010, and that it is now starting to recover. The widely derided state of the housing market is at least stable and is even starting to show some tentative signs of improvement. We should also bear in mind that affordability is high and mortgage rates at record lows. Unemployment remains very high at around 9% but also has a silver lining as it acts as a dampener of wage pressures and therefore core inflation. Confidence surveys are very low, but these are affected both by the stock market and by the persistent
over-reporting of bad news by a media industry plagued by overcapacity. Activity levels, in contrast, especially the much analysed monthly surveys of Manufacturing and Services by the Institute of Supply Management, paint a much healthier picture.
Not only do we believe that the United States economy is none too shabby but we also see healthy signs from China, the world’s second largest economy. The official data indicates a soft landing (meaning a slowing of growth rather than anything worse); manufacturing is holding steady, the services sector is still growing rapidly and inflation looks to be peaking. More importantly to us we are neither seeing, nor hearing, companies trading with China describing anything other than very healthy growth.
This peaking of inflation is very important. Both hard and soft commodity prices have been falling over the summer in response to tight credit markets, slower global growth and improved agricultural conditions. This is reducing pressure on non-core inflation across the world, meaning that we expect the tightening monetary conditions in a number of emerging economies to come to an end, and that we believe interest rates across the developed world will stay at exceptionally low levels for a very long time.
In turn this means that although yields on bonds, especially gilts, have hit record lows this year, we are dubious that we shall see meaningful rises in the near or medium term. Inflation should fall quickly in early 2012, while the pressures on public finances that we discussed earlier mean that an increase in government borrowing costs is highly undesirable. The expected drop in inflation however does not mean that we have revised our long standing positive view on index-linked gilts which should continue to provide attractive and stable returns. Nor do we see gold falling out of favour for anything other than the short term; gold is the archetypal investment in fear, this being one commodity for which we see persistent strong demand.
Europe is the conundrum that must be resolved. If the politicians and central bankers can agree on one of the many possible solutions to the debt issues the markets will very quickly stabilize. But for as long as they continue to prevaricate, greater grows the danger of precipitating
another banking crisis. More than ever, investment portfolios need to be diversified and of the highest possible quality
October Market Commentary
Williams de Broe
