Summary
- Commodity prices fall sharply as supply increases and demand falters.
- UK and European economic deterioration brings forward expectations of rate cuts.
- Bond and equity markets rally on prospects of lower inflation and lower interest rates.
- Shares in cyclical companies (banks, media, retail) recover from lows.
Commodity Prices Fall Sharply
July was another rollercoaster month for markets as
commodity prices peaked and the economic news proved to
be generally better than expected in the US, but disappointed
in the UK, Europe and Japan. We have been anticipating a fall
in commodity prices, and oil in particular, but the speed with
which oil, metals and agricultural commodities have fallen
in unison has been remarkable, with a 12% decline in the
DJAIG commodity index in the month of July alone. Lower
commodity prices imply a lower rate of inflation in 2009 and
mean more scope for central banks to reduce interest rates
to support economic growth. This provided the catalyst
for a rally in equities, with the UK stock market up 5% from
the lows reached in the middle of July. It also supported the
bond market, with 10 year government bond yields falling
from 5.1% to 4.8% over the month for a 3% total return.
Economic Outlook Mixed
In the US, the current low interest rate policy (a 2.0% funding
rate for banks) and tax cuts helped consumer confidence to
pick up and industrial production to grow solidly. However,
there are still no clear signs that the housing market is
stabilising and without this there remains the risk that, with
the benefits of the tax cuts now behind us, the US economy
may weaken again. The consensus expectation is that we will
see a further modest slowdown in the second half of this
year before a recovery in 2009. This is supported by a falling
rate of wage growth, which allows the US Federal Reserve
more lattitude in maintaining their low interest rate policy
for longer.
The UK has seen a marked deterioration in the economic
outlook, with a survey of manufacturers expectations the
worst for 10 years (see chart overleaf) and a sharp fall in retail
sales. With interest rates at 5.0%, demand slowing and input
prices up by 30% over the past 12 months, manufacturing is
beginning to struggle, in spite of a favourable exchange rate.
It now appears likely that the UK will have negative growthfor the next two quarters. This makes it more likely that
interest rates will be cut in October, even though inflation
may have reached 5% by then.
Europe has finally succumbed to the strong euro and a
collapse in property prices in Spain and France. The Germaneconomy is now expected to have contracted by up to
1.5% in the second quarter and with interest rates having
been raised in July, growth is likely to be negative again
in the current quarter. Jean-Claude Trichet, president
of the European Central Bank, last week acknowledged
that conditions had deteriorated, thus removing any
possibility of further rate rises. The result has been a
sharp depreciation in the euro and sterling against the
US dollar over the past week. Having increased our
exposure to US equities last quarter, this currency move
has benefitted client portfolios.
Cyclical Equities Recover in UK
The question now is whether the anticipated fall in UK
interest rates in Q4 this year will underpin equities in the
face of a deteriorating economy.
In the cyclical sectors such as banking, media and retail,
much bad news has already been factored into share
prices with earnings projections for 2008 having been
cut sharply. Lower interest rates are particularly helpful
to these sectors, so it is not surprising that banks and
retailers were some of the best performing shares over
the past month (+12%). Despite this, share valuations
remain cheap, pointing to the scope for further gains in
these sectors. It is no coincidence that two companies
in our Alpha portfolio (Michael Page and Collins Stewart)
were subject to takeover bids in the past few weeks as
attractive current valuations make companies vulnerable
to predators. It is in these sectors that our portfolios are overweighted.
Mining companies, where we are underweighted, were
amongst the worst performing sectors (-22%). Here,
although share prices have fallen, earnings have not been
downgraded to reflect lower metals prices, so this sector
remains vulnerable.
Overall company earnings have been downgraded by some
15% in the UK. We anticipate further downgrades as the
economy deteriorates and the result will be continued
volatility as different sectors are affected by the progress
of the cycle. Our focus on undervalued shares with strong
balance sheets gives us confidence we can take advantage
of these developments. Fundamentally, the UK, European
and Japanese markets are cheap, and though they could
become cheaper in the short term, this is a good time for
the longer term investor to be buying.
Japanese Equities Remain Attractive
Despite a weakening in the Japanese economy, Japan
remains the cheapest equity market in valuation terms
(see below) and we have increased our exposure to a 3%
overweighting relative to benchmark.
Matthew Hunt
22 Rathbone Street, London W1T 1LA
T: +44 (0)20 7413 2799 F: +44 (0)20 7413 0988
www.prospectwealth.co.uk
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