Rising interest rates, oil hitting £80 a barrel and a slowing American housing market all had a significant impact on the global economy in 2006. Adam Lewis looks back on the highs and lows of the past year.
Sadly for fans of English football, 2006 was not the year when England regained the World Cup. Instead, penalty shoot-outs, headbutts, the retirement of a Formula One great, Europe retaining the Ryder cup and a dodgy lasagne (ask a Tottenham fan) are but a few memories of the past 12 months.
Away from sport, many of the news stories dominating 2006 had the common theme of a feeling of fear. The year saw nuclear testing in North Korea, Israel and Lebanon go to war and Saddam Hussein sentenced to death by hanging. There was also a warning by Tony Blair of imminent climate change catastrophe, the killing of a former Russian spy and this month’s emerging story of a serial killer murdering prostitutes.
In market terms, 2006 was a year that saw the global economy continue to grow strongly, rises in global interest rates, oil hit $80 a barrel, and signs of slowdowns in both the American and Japanese economies.
Continuing the overriding macroeconomic theme of last year, 2006 is the third year in a row when the global economy has demonstrated strong growth. Despite a clear slowdown in America, Sebastian Mackay, economist at the Scottish Widows Investment Partnership, says global growth is set to hit 5% for the year.
Mackay notes that America has performed broadly in line with expectations. The eurozone, however, has exceeded them. At the start of the year Europe’s GDP was expected to grow by 2% in 2006; Mackay says growth looks like it will come in at 2.7%. This is the first time since 2001 that Europe’s GDP growth will surpass 2%.”2006 was the year that Europe’s corporate sector started to expand again,” Mackay says.
After years of retrenchment following the bursting of the tech, media and telecoms bubble in 2001, he adds, investment spending picked up this year as corporate balance sheets were repaired and external demand was strong.
Andrew Milligan, head of global strategy at Standard Life Investments, says the deceleration in the American economy is one of the stand-out themes for the year. “Back in January people were expecting the world economy to have a good year, but they would have been surprised by the extent of the slowdowns in both America and Japan going into autumn,” he says.
Milligan adds that the US slowdown was caused by rises in interest rates, mortgage rates and raw materials costs, all of which combined to squeeze the incomes of both consumers and companies. “From spring forward a housing market recession began to appear, which is beginning to ripple out into manufacturing and other parts of consumer spending,” he says.
In the issue of September 11, Daniel Ben-Ami, editor of Fund Strategy, examined whether the American slowdown would hit the Asian emerging market economies. Or had Asia “decoupled” from America enough not to be hurt badly by a slowing economy across the Pacific?
Michael Jennings, head of global equities at Morley, says so far there are no signs of an Asian slowdown following the one in America. However, he adds, the biggest economic question in 2007 is whether or not China can continue to grow at its present 9-10% rate as America slows.
Jennings says: “The debate all year has been whether or not the US will suffer a hard or soft landing. Now all economists are saying it will be a soft landing.”
The area of the American economy that has slowed the most over the past few months is housing, Jennings says. “New home sales have fallen off the edge of a cliff, but the big question economists have been asking is does this matter and will it affect the rest of the economy?” he explains. “At present, none expect a hard landing.”
Historically, a slowdown in the world’s largest economy has a big impact on the rest of the global economy, hence the often-used phrase “when America sneezes the rest of the world catches a cold”. However, Jennings says economists now say that as the Chinese and Japanese economies have become more self-sustaining, they may be in a position to withstand such a slowdown.
“Most economists assume the US will be in for a soft landing and the Chinese economy will be relatively unaffected,” he adds. “The worry is that both these assumptions turn out to be wrong.”
While the American economy may be about to enter the slow lane, global equity markets have had a generally strong 2006. At the start of the year, year-end predictions for the FTSE 100 were between 5600 and 5800. However, following a strong start to the year, the FTSE passed the 6000 mark on March 22. It fell back below this following the global equity sell-off in May and June, but has been above 6000 since October. At close of play on December 14, the index stood at 6253.
Meanwhile, the S&P 500 started the year at 1248 and was not predicted by many to go far beyond the 1300 mark over the year. In the issue of January 9, 2006, Swip predicted the S&P 500 would end the year at 1290 and Legal & General forecast a level of between 1280 and 1330. However, in November the index broke through the 1400 barrier, and as at close of play on December 14 it stood at 1487.
“Equities globally had a very strong first four months of the year,” Jennings says. “Then there was the sharp sell-off, which lasted for about six weeks, starting in May and ending in mid-June. Over this six-week period the world equity index fell about 10%.”
Jennings says the sell-off was the result of a growth scare caused by fears that China was slowing, and that interest rates rises in America would cause it to slow further. “The slowing of the major drivers of global growth saw oil prices fall from the high $70s a barrel down to the $60s, where they have stayed ever since,” he adds.
If asked at the start of the year whether or not he would have expected a sell-off in global equity markets, Milligan says his answer would have been “yes”. “It would be unusual for a year to go by without a correction,” he says. “We saw something similar in 2004. It is the timing that is always the surprise. On this occasion it was caused by a mixture of global liquidity being withdrawn quickly by central banks and overconfidence about the prospects for emerging markets.”
Since the end of June, Jennings notes, equity markets have risen relatively smoothly as two important things have happened. “First, corporate earnings have been strong,” he says. “Third-quarter earnings in the US showed a 19% rise. Indeed, relative to a year ago, US corporate earnings have been much stronger than the market expected and profit margins are now at multi-decade highs. Second, there has been strong liquidity.”
Indeed, Milligan says 2006 has been the best year since 2000 in terms of M&A activity. This, he notes, has been associated with large amounts of private equity and credit market activity. Jennings says private equity firms have raised $400bn (£204bn) between them this year, which has been used to buy utility, tobacco and port companies. Jennings assumes this liquidity-driven rally will continue into 2007, as long as interest rates remain relatively low.
Indeed, Mackay says that risky assets as a whole have had a good 2006, added to a large degree by loose global monetary policy, meaning the cost of borrowing has been cheaper than expected. In Britain, interest rates began the year at 4.5% and most commentators predicted this to be either unchanged by the year-end, or for there to be one quarter-point cut. Instead there have been two quarter-point raises – one in August and one in November – which have taken the rate to its current 5% level.
In America, meanwhile, rates started the year at 4.25% and successive raises by the Federal Reserve in the first half of the year took them to 5.25%, where they have stayed since June. The European Central Bank has made five quarter-point rises over the year, taking rates in Europe from 2.25% at the start of the year to their current level of 3.5%. Most commentators expected the ECB to make just one quarter-point rise.
Milligan says: “The surprise this year has been the continued rate rises in the UK and Europe. These have been the countries that resisted any economic slowdown. Britain has been held up by continued domestic consumer spending, while exports to Asia and the Middle East have held up Europe.”
Meanwhile, 2006 heralded the Bank of Japan’s decision to abandon its zero interest rate policy and raise rates for the first time in five years. In July it raised rates to 0.25%. Unlike the other global rate rises, this quarter-point rise was widely predicted.
Keith Wade, chief economist at Schroders, says something that was less expected was the Bank of Japan’s decision in April to end its policy of quantitative easing. He notes this decision coincided with the global market turbulence in May and saw the yen strengthen significantly.
So far, Wade notes, the quarter-point rise in interest rates has not had a significant impact on the Japaneseeconomy. “The household sector is not a big borrower in Japan,” he says. “Indeed, cash balances exceed their debt levels.”
One of the main themes of 2005 was the strength of Japan’s domestic recovery. Wade says this did carry on to the first quarter of 2006, but since then it has been a year of disappointment for Japan. This, he says, is a result of weaker-than-expected domestic consumption and wage growth.
However, he notes that similar to America, corporate profitability in Japan continues to improve, despite economic weakness. “2006 has been a year when profits have done well at the expense of labour,” he arguesCompared with last year’s 40% return on the Nikkei 225, so far this year the index has only returned 3.6%. In sterling terms, it is down 9% for the year. Indeed, of the major world equity markets, Japan is 2006’s weakest performer, with other world equity markets returning 10-15% on average.
However, while the stockmarket has disappointed, the economy has exceeded expectations. Jennings says at the start of the year the consensus for Japanese GDP growth was 2.2%, whereas it is now set at 2.7%. “Generally the Japanese economy has grown better than was expected, but it has shown some signs of weakness in the past couple of months,” he notes.
Mackay adds: “The end of the zero rate policy is confirmation that the Japanese economy has returned to normality. Non-performing loans have cleared up, deflation seems to have about come to an end, and bank lending and land prices have both picked up. While growth has not been overexciting this year, the big picture is that the economy has returned to normality.”
In terms of sectors, oil and materials had a strong first half of the year, with oil prices starting the year at $60 a barrel and peaking at $80 in August. The oil price has since fallen back to nearer $60 in a weaker second half.
Mackay says: “When the oil price hit the $80 mark there was concern about its possible impact on the global economy. However, in general the economy managed to shrug it off. The pick-up in price was a reflection of both strong growth and strong demand, but in the end prices did not stay high for long.”
Milligan says the fall-back in oil price is important because it removed uncertainty from financial markets as to the direction of interest rates, and allowed world equity markets to rally into the autumn.
Jennings says that the best global sectors to have held in 2006 were utilities and telecoms, which he adds is odd as both are considered “defensive”. He explains: “These sectors have outperformed for two main reasons. First, they both tend to be bond proxies, and bond markets have done well this year. With bond yields remaining low, utilities and telecoms have been attractive.
“Second, private equity firms look for stable businesses with strong cashflows, and utilities and telecom companies fit this bill. So there has been strong M&A and rumour activity, especially in the utility sector.”
Overall, then, 2006 saw a manageable economic slowdown combined with generally strong equity returns. No single event defined the year but markets managed to negotiate several shocks and panics along the way.
Fund industry developments in 2006
There were many striking developments this year in the fund industry. One of the most eagerly anticipated was Fidelity’s splitting of Anthony Bolton’s £6bn UK Special Situations fund. With Bolton set to retire from Fidelity at the end of 2007, the group announced in June that it was to split the fund into two, with half of investors’ money staying in the UK portfolio and the rest going into a new Global Special Situations fund, to be managed by the then little-known Jorma Korhonen.
The fund was eventually split into two in the middle of September and the group will this year announce Bolton’s successor on the UK portfolio in the run-up to his retirement.
May was an important month for Gartmore after it secured its future following a private equity-backed management buyout. Hellman & Freidmann provided the injection of £500-600m for the MBO, after Gartmore was put up for sale by Nationwide Mutual, its parent at the time. However, following the buyout it was announced that Philip Ehrmann, manager of the group’s China and Emerging Market Opportunities funds, was to leave the group as a result. In July Ehrmann joined Jupiter, which has since launched a China equity fund for him to manage.
Jupiter was involved in another big-name hire this year, poaching Ben Whitmore from Schroders. The former manager of the Schroder Recovery fund joined the group in November, taking over the UK Special Situations fund from Paul Sheehan.
Barings has also had a busy year. In the middle of the year it lost most of its emerging desk to Resolution’s new boutique, Hexam, then in November it was announced that David Kiddie, its head of equities, was to leave the group to join ABN Amro Asset Management as chief investment officer.
In other manager changes, October saw the announcement that Errol Francis, manager of three Credit Suisse Income funds, was to leave the firm. Francis is set to join Shroders in the new year, where he will work with Richard Buxton as a fund manager in the UK equities team. The move caused Bill Mott, former manager of the funds, to delay his retirement until the end of this year. In 2003 Mott stepped back from portfolio management to an advisory role.
Francis’s exit followed the high-profile departures of Ian Chimes and Mark Thomas, respectively the managing director and retail sales director of the firm’s asset management division.
HSBC has also had a busy year. In September it announced its intention to transfer its UK Growth and Income, Income and Monthly Income funds – worth a combined £2bn in assets – to its multi-manager team. Subsequently, managers Bob Morris, manager of the Growth & Income and UK Freestyle funds, and Chris Rodgers left the group.
The UK Growth & Income fund is now 20% managed by Edinburgh Partners, 40% by Mirabaud, with the remaining 40% run by GMO. The Income fund is 40% managed by GMO, 30% Edinburgh Partners and 30% Walker Crips Weddle Beck. The Monthly Income fund is now managed by Synopia, HSBC’s quantitative asset management division.
The hard closing, or “capping”, of funds was also in the news this year. In January JP Morgan Asset Management announced it would close its £401.4m (at the time) JPM UK Dynamic fund, when it reached a capacity of 610 million shares. The fund, managed by Ajay Gambhir, reached this milestone on March 3.
Following JPM’s lead, in November Old Mutual Asset Managers announced plans to hard-close its UK Select Smaller Companies fund. Run by Dan Nickols, the £540m fund closed to new investment last week after reaching 350 million units in issue.
Lastly, GAM announced this month that it plans to hard-close Andrew Green’s UK Diversified and Global Diversified Oeics. The UK fund will be capped at 88 million units and the Global fund at 40.5 million. If they do not reach this size by December 29, both funds will be closed for new investment on that date.