On the Hoof
Bedlam Asset Management
July 13, 2012
A good month for equity markets and for the portfolio, with both enjoying significant rises of around 3.2%. These took place against increasing evidence that economic activity is beginning to slow, yet again demonstrating the lack of correlation between economic growth and equity market returns. Although such a large monthly index gain is unsustainable (simple compounding would make the 12-month return 46%), it should not surprise if the pattern continues of equity markets producing reasonable total returns (with dividends becoming more important) against a worsening economic and political background. The primary cause is a simple flight to real assets. Even a hermit must now be aware that cash and government bonds mostly offer negative real yields; although yields on pockets of property are better, often capital values are declining. Just as in foreign exchange trading globally the gains and losses should always equal zero, so in the industrialised countries where consumers and governments continue to carry too much debt, there must be a balancing surplus somewhere else. This lies in the record level of net cash in company balance sheets, which continues to rise.
The 19th emergency Eurozone Summit (sic) in five years took place at the month-end. That it produced so little shows how policy continues to lag events, is reactive and made on the hoof. As for most previous summits, the two real issues of how to avoid losses being taken (sovereign default) and encourage inflation were not discussed. The agreement arrived at did produce incremental steps along the correct path: plans for an economic growth package; direct funding by the European Stability Mechanism (ESM) of insolvent banks (so a separation between the sovereign and the banking sector debt spiral); and the creation of a eurozone bank regulator by the end of 2012. The ESM, however, had its funding capped at €500bn. A third of this has already been committed. It also exists to support government bond auctions; the government debts of Italy and Spain alone are €2.8 trillion (six times the ESM‟s gross fire power). Hence these “revolutionary” changes do not reduce the probability of default by some PIIGS nations and certain others (such as Cyprus). The €120bn growth package was hardly worth the effort. Apart from lacking a timetable, but likely to be for a minimum five-year period, this stimulus will only equate to less than 0.2% of eurozone GDP p.a.
This state of denial is not confined to the derided eurozone political class. The Bank of England, lacking more coherent policies, decided to throw another £50bn into supporting the gilt market. China cut interest rates in an increasingly desperate attempt to stimulate its economy, which is expanding at far below the much touted 8% annual level. In the US, the Fed is sitting on its hands waiting for data to become sufficiently bad to justify further easing, highly controversial in a Presidential election year. Most of the economic data announced has been like an old Italian Vespa, sputtering along noisily but feebly. The June Purchasing Managers‟ Indices for nine of the G10 countries showed contraction, as did June ISM data for the US - at 49.7 versus 59.5, with new orders shrinking significantly from 60.0 to 47.8. Eurozone unemployment rose to its highest level since the creation of the single currency, at 11.1%; in the US it remains stubbornly above 8%.
Neither the plethora of weak economic data nor its continuation should be unexpected. The only new development since mid-2011 has been evidence of accelerating deflation. Its consequences for funding budget deficits and sovereign borrowing are grim. Not only does deflation destroy the tax base, it ensures economic contraction similar to Japan‟s „lost decade‟. Fear of deflation guarantees yet another heave by the Fed, the Banks of England, Japan and China as well as the European Central Bank to attempt further stimulatory policies, all on the hoof.
Governments remain in a policy vacuum, save for continuing to rig interest rates at close to zero (the irony of their howls over Libor fixing allegations has passed them by), and further fiscal and monetary stimulus to avoid losses on sovereign and other debt obligations. These are inevitable.
Yet such actions will continue to provide major support for equity prices given they represent not only real assets but a lower risk, with better and more sustainable yields. Another factor favouring equities is valuations. In many developed markets, particularly Europe and Japan, these are now at bottom quartile levels from which historically good gains have been made. The continuous failure of new issues also helps because markets are not being swamped with supply, whilst the natural reinvestment of dividends and still-high levels of share repurchase programmes also act as floors. Moreover, many companies are changing their dividend policies from often miserly to more generous pay-out ratios. This has created a yawning gap between growing equity yields and those of other asset classes. Correctly, the imminent half-year reporting season for some sectors is expected to show a deterioration; financials (of course), high-tech, heavy industry, most mineral extraction (apart from precious metals), and luxury consumer goods. Yet much of this weakness is offset by good earnings growth in many other sectors, aided by continuous cost-cutting. The very different directions taken by equity markets and economic activity look set to continue.
To an extent markets were buoyed up by the false expectation of greater stimulus from the eurozone and the US. The only nonsurprise was the Bank of England deciding to take on more debt, despite the UK‟s current account and budget deficits being in the worst fifth of the G20 nations. The top-performing sectors were rational given all enjoy accelerating earnings and reasonable-tolow valuations. Telecoms (8.7% of the portfolio) was one, still largely driven by data growth in smartphones. Three other sectors stood out: precious metal shares, reflecting the move into hard assets; soft commodities because indications for the 2012 harvest suggest a serious squeeze in grain production; and energy. This last sector was propelled by the 33% gain in the US natural gas price from its recent low-point in mid-May, resulting in strong rises by Southwestern Energy and Ultra Petroleum.
It is often the case that the least discussed and most "unpopular" market puts in the best returns. This proved to be the case with Japan. All five portfolio holdings there made a positive contribution. The best was Softbank, the telecoms/internet group which was added to at the start of the month. This was in part because of management changes, and also due to a gradual restructuring of its array of business interests in China, in Yahoo! Japan and elsewhere; hence earnings visibility is improving. After the month-end, it announced consensus-beating results. Perhaps surprisingly, the next best contributor geographically was Europe ex-the UK. However, of the portfolio‟s 25% within the region, more than half is in non-eurozone countries, thus less affected by that area‟s woes.
Only one new investment was made, Taiwan‟s Far Eastone, the best value and fastest growing of the 3G/4G telecom operators. Also in Taiwan, the holding in the leading bicycle maker Giant Manufacturing was topped up. Santos, the Australian oil and gas company, was sold because its catalysts are slowly fading and costs are rising too rapidly. However, given that the natural gas story globally continues to improve due to its huge competitive price (and sometimes transport) advantage over coal, nuclear and all other forms of energy for electricity generation, most of the sale proceeds were switched into the two US gas companies already mentioned. Symantec was sold because despite frequent conversations with the company, it is difficult to understand why revenue and margins are lagging against its peers. Some profits were taken in the US/Mexican railroad group Kansas City Southern after a strong run in its price and good results. Cott, the generic North American soft drink producer, was also reduced after a 35% share price gain since January.
Bedlam Asset Management plc is authorised and regulated by the Financial Services Authority (212757). Bedlam Funds plc is regulated by the Central Bank of Ireland pursuant to the European Communities (Undertakings for Collective Investment in Transferable Securities) Regulations, 2003 as amended by the European Communities (Undertakings for Collective Investment in Transferable Securities) (Amendment) Regulations, 2003 (the "UCITs Regulations") and is a recognised collective investment scheme for the purposes of section 264 of the United Kingdom Financial Services and Markets Act, 2000. Shares in Bedlam funds plc may only be sold on the terms of, and pursuant to, its most recent prospectus. This document is not investment advice or a recommendation to purchase, hold or sell a security. Past performance is not a reliable indicator of future results.
(c) Bedlam Asset Management
