Long-term risks temper optimism

2 November 2009 | By Chris Murphy

Chris Murphy is the manager of the Aviva Investors UK Equity fund

The FTSE 100 index hit a six-year low of 3,512 on March 3, 2009, as fears of a systemic collapse in the global banking system and a deep and prolonged recession drove extreme levels of equity volatility and risk aversion. Roll forward two quarters and this fear has been replaced with optimism over the pace and extent of the global economic recovery. Fiscal measures by governments and central banks to inject stimulus into their economies appear to have worked.

With fear and panic subsiding across financial markets, institutions - suddenly awash with cash and with the return on risk-free assets such as money market instruments and government bonds looking unattractive - have been putting their funds back to work in riskier asset classes such as corporate bonds and equities. This, combined with a sharp turnaround in economic sentiment and some extreme valuation anomalies, particularly financially-distressed businesses, has helped drive a sharp rally in the British equity market.

So do equities still offer good value, and is the rampant optimism over the economy to be believed? In aggregate, equity valuations do not appear expensive when observed on a normalised price to earnings basis. However, particular parts of the market are stretched. Many cyclicals such as financials, miners and consumer cyclicals led the rally and are pricing in a sharp recovery in both economic conditions and corporate profits. Conversely, this has led to some of the more defensive areas of the market being overlooked. Many pharmaceutical shares, for example, are trading at 15-year lows despite offering a combination of defensiveness and growth with the further benefit of healthy dividend yields.

Any additional gains from the British equity market require further signals that the economy is in a long-term recovery phase, and a broadening out of this rally into other areas of the market.

”Britain’s manufacturing base has shrunk to a higher-value-added core, with greater exposure to emerging markets and more scope to control costs”

The share prices of many banks have risen sharply as the immediate risk of collapse has been averted and loan provisions (for loans that have turned sour) will peak either this year or next. However, it will probably take many years before earnings return to anywhere near the level they were at until recently, as both banks and their customers have to reduce debt levels - not to mention the impact of stricter regulatory supervision. Given this backdrop, and the likelihood many banks will be forced to boost capital cushions further, bank lending looks set to remain depressed for some time.

Industrial and mining shares have also performed well. This is because many industrial businesses were better placed than in previous downturns. Britain’s manufacturing base has shrunk to a higher-value-added core, with greater exposure to emerging markets and more scope to control costs than was the case historically. The miners have been driven by a return to buoyant expectations for emerging market growth. The prices of many metals have responded to increased demand, although this is largely the result of one-off stockpiling as the Chinese take advantage of cheaper prices to support long-term infrastructure projects.

Mergers and acquisitions should become an increasingly important factor. In an environment of low economic growth, companies will be eager to secure synergies to drive earnings growth. In the same theme, cost reduction programmes should temper wage inflation and continue to restrain dividend policy - this will make the yield concentration in particular areas of the market even more extreme.

 

Government budgets will come under pressure given extremely high levels of public sector debt. This could result in increased outsourcing of government services over the next few years, benefiting technology and support services companies.

So, is the economic backdrop supportive of further equity gains? I am a bit more pessimistic on the prospects for the British economy than many sell-side analysts. While a period of prolonged and moderate growth is likely, there are several events that have the potential to derail the recovery. Rising concern about the medium- to longer-term outlook for inflation could propel bond yields higher. This would drive up the cost of corporate and consumer borrowing, while simultaneously reducing the relative attraction of risk assets.

Another challenge is the enormous amount of monetary stimulus that has left central banks in uncharted waters. There is great uncertainty both about when and how it will be removed. This is a process that is likely to be fraught with difficulty.

There is also a risk of a prolonged period of sub-trend growth in western economies as structural imbalances are unwound and the consumer battles against a variety of headwinds. In view of the excess liquidity in the system, there is a possibility that assets once more enter bubble territory, with prices that cannot be justified by the economic backdrop.