May 02 2012
"There are really two kinds of risk: short term and long term. Short-term risk is the knot we get in our stomachs when our portfolios lose 20% or 40% in value over the course of a year or two. It is a fearsome thing. Strangely, human beings are not as emotionally disturbed by long-term risk as they are by short term risk. Short term risk, occurring over periods of less than several years, is what we feel in our gut as we follow the market from day to day and month to month. It is what gives investors sleepless nights. More importantly, it is what causes investors to bail out of stocks after a bad run, usually at the bottom. And yet, in the long-term, it is of trivial importance. After all, if you can obtain high long-term returns, what does it matter if you have lost and regained 50% or 80% of your principal along the way?"
William Bernstein, Four Pillars of Investing.
Bad news flows
Last week saw a succession of bad news. The UK apparently slipped back into recession. So did Spain - and had its debt downgraded just to rub the country's nose in it. Economic growth in the US was disappointing - as was data for durable goods and job claims. And the French election results showed not only the reality of the rise of the extreme right but also the prospect of a socialist government clashing with Germany over policy. All in all it wasn't pretty. According to Bank of America Merrill Lynch index data, fixed income assets were the place to be - with almost all bond markets showing modest but positive returns over the last month.
So how did risk markets react? Was it 'risk off' all over again? Actually no - investors held their nerve and markets remain relatively resilient. Bloomberg report that the MSCI All-Country World Index fell only 1.1% - while cyclical equities actually outperformed. As for commodities, the Standard & Poor’s GSCI Total Return Index of metals, fuels and agricultural products fell by only 0.5%. So why were investors so much less anxious this time? Well, part of the reason is that equity markets had already retreated from their highs in mid March. At that time they had, arguably, moved too far too fast and were due a correction. But we would also suggest that the other important factors that were at play were a growing sense of realism, current investment positioning, corporate earnings and current valuations.
A growing sense of realism
Once you move away from the media obsession with financial meltdown, most professional investors have readjusted their expectations to take account of a slow, weak economic recovery. Part of this means accepting that there will be times when data will disappoint. And the UK preliminary GDP numbers are a very good case in point. They point to a 0.2% decline in the first quarter - something the Monetary Policy Committee called “perplexing”. In our view, the numbers are wrong and we expect them to be revised upwards. This may encourage the cessation of quantitative easing, as there are those who are getting increasingly concerned about inflation - something we are not convinced is an entirely bad thing. In the US, the Federal Reserve revised growth numbers down to 2.5% (below the consensus forecast of 3%) and left the option of further easing open. But we had expected the US numbers to be weak so this came as little surprise to us.
Current investment positioning
Whilst traders continue to speculate over the future of Europe, in particular, most longer term investors have already made up their minds as to their positioning. Equity weightings are low historically, just as weightings in Government bonds still perceived as 'safe' (that's essentially US Treasuries, German Bunds and UK Gilts) are historically high. As a result, the pressure to move out of 'risk assets' has, to some extent reduced.
Amongst all the bad news were a few items of rather better news. Accepting that expectations were low, first quarter earnings in both the UK and the US have been some 3% above consensus forecasts according to Goldman Sachs. According to Bloomberg, 42% of those companies in the STOXX 600 that have reported have beaten estimates by more than 5% - and only 27% have missed estimates by more than 5% (compared to 37% historically).
Current equity market valuations look reasonable given the current outlook - the FTSE 100 index is currently on a forward P/E of 10.1x and the STOXX Europe on 10.3x. In the latter case, the key for assessing the impact of further drama in Europe lies in understanding what is already priced in. We would argue that a lot of the bad news already is. Just look at how cheap some of the European banks are. So, on that note, let's turn to Europe once again…
Go for growth!
Everyone is getting weary of the never ending European drama. As Kanye West put it "It's been a while since I watched the tube cause like a crip said: I got way too many blues for any more bad news." But there are some signs that things are reaching a head. It seems that, finally, the penny (well, strictly speaking the euro) has dropped. After years of blinkered procrastination, Europe's leaders seem to have finally understood that economic growth is needed - not simply endless cost cutting, budget controls and austerity. Of course the next stage will be getting them to agree on what to do about it. It is clear that there will be differences between the German and French positions at the very least. But surely the time has come when even the politicians realise the scale of the human tragedy they have caused? Unemployment in Spain is at 24.44% according to the INS - and at 33.17% in Andalusia. And almost 10% of the French workforce - that's some 2.9 million people - is out of work. France has now lost more industrial jobs than any European country over the last 10 years. No wonder François Hollande says "It’s not for Germany to decide for the rest of Europe. If I am elected president, there will be a change in Europe's construction. We’re not just any country: we can change the situation." It remains to be seen if he can.
Fat pigs and mad cows
Commodities markets have struggled recently and the short term outlook remains mixed. In the US, they have reached the largest pig population on record (some 117.1 million pigs will be raised there this year) and they are also the heaviest according to Bloomberg. With China also increasing production, "There’s plenty of pork," as John Nalivka, former USDA economist succinctly put it. The fourth case of BSE in California has also undermined cattle prices, whilst weak economic growth has left industrial metals and oils struggling to find support. Gold has held up, with the International Monetary Fund reporting significant central bank buying.
Sell in May, and go away; don't come back until St Leger day
With so much bad news around it’s tempting to follow the old adage and remain on the sidelines. And we certainly do expect a lot of investors to do just that and sit on their hands for the short term. But we want to be 'in the market' as the recovery slowly grinds onwards. As Morgan Stanley put it the recovery is 'BBB' - Bumpy, Below-par and Brittle. We accept there is little obvious good news on the horizon, and that there is plenty of potential for more depressing news. This is likely to mean that there is little to buoy up equity markets in the short term. As before, if that does upset markets then we see that as opportunity. The next few months certainly promise to be interesting - Jim O'Neil, Chairman of Goldman Sachs Asset Management, for Governor of the Bank of England?
Having started with a quote form William Bernstein let's finish with one too: "High-risk societies - or crisis periods in stable societies - result in high investment returns - if those societies survive."
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