Investors resorted to severe remedies as fears of subprime contagion arose. However, when key tests are applied, the US market’s basic good health appears unchanged. Expect a full recovery.
In the early stages of an illness it can be difficult to make an accurate diagnosis. What does the first sneeze portend? Is it just the first symptom of a debilitating bout of influenza, or nothing more serious than a 24-hour cold, readily eradicated by the application of tea and sympathy?
Earlier this year, faced with falling house prices and signs that American homeowners were struggling to keep up mortgage payments, Wall Street remained a picture of good health. Worries about subprime contagion into the wider market were soon shrugged off. The S&P 500 hit record highs.
But as soon as Bear Stearns, an investment bank, was compelled to bail out two hedge funds with exposure to subprime debt, Wall Street’s tough-guy act crumbled. Almost overnight the market turned into a hypochondriac, taking to bed with an armful of remedies and vitamin tablets. Not only did investors try to sell any collateralised debt obligations that might hold the toxic subprime debt but they purged their portfolios of any financial instrument that might have been exposed to the infection, fleeing from hedge funds of every hue, indiscriminately selling off equities, particularly financial stocks.
Was this an overreaction? We think so. The subprime issue has clearly infected the wider economy: lending rates in the money market have spiked higher; banks seem to have lost confidence in each other; quant-driven hedge funds are in the red. But while it will take time for the dust to settle, we remain confident that many American stocks have a healthy future. And, despite all the moaning, the S&P 500 is only 5% off its high at the time of writing. In our view the prognosis for the equity market as a whole is better than some investors believe.
Why? Because when we look at the 40 stocks in our portfolio, we ask ourselves these questions: 1 Will seven million US households simply walk away from their mortgages? 2 Are the world’s central banks powerless to stop a global recession? 3 Is Chinese growth going to stall or go into reverse? 4 Will the power plants, petrochemical facilities and hotels due to be built worldwide simply be mothballed?
Our answer to all these questions is a firm “No”.
After years of rapid expansion, American economic growth is slowing. But it is not collapsing. Unemployment is only 4.6%. Recent surveys showed jobs to be “plentiful”. The strength of the employment market should continue to offer support to the wider economy, even as house prices fall. Tales of reckless mortgage lending and consumer debt problems are nothing new – HSBC’s Household International confessed to having made some poor lending decisions several months ago. We have been highlighting the unsustainably high levels of consumer debt in our client reports for some time, and predicting that the unwinding of this debt burden would have an impact on the American consumer’s insatiable appetite.
However, the pain is far from universal. If there really was a widespread meltdown in consumer spending, we would expect to see all American retailers struggling. But three of the sector’s high-profile constituents – JC Penney, Kohl’s and JW Nordstrom – reported excellent results and even indicated that analysts should revise up their earnings forecasts. Wal-Mart did disappoint, but Wal-Mart is much more exposed to the area of the American workforce that is dependent on subprime mortgages. A stockpicker’s portfolio is not obliged to hold both JC Penney and Wal-Mart.
Why does China matter? Because many American stocks are, in reality, global businesses, buying and selling in global markets but listed in New York for historical reasons. This year China became, for the first time, the largest single driver to global economic growth. GDP growth in China remains prodigious. Macro data there, from industrial production to fixed-asset investment, and from retail sales to exports, remains defiantly robust. Despite yet another increase in GDP growth during the second quarter (to 11.9%), China’s State Council said that the Chinese economy was not overheating. So, the global economy into which American companies sell their products has multiple engines to keep it airborne should America splutter. And thanks to this year’s weakening in the dollar, American companies find themselves newly competitive in this buoyant international marketplace.
The ongoing period of global economic expansion is unprecedented, both in its duration and in its rapidity. This growth has placed strain on many elements of economic infrastructure the world over. There is a real shortage of power generating plants, of shipping capacity, of offshore oil rigs and even of hotel rooms. Many of these sectors have suffered from chronic underinvestment for years. And while yields on junk debt have spiked up, yields on quality debt have fallen, encouraging operators in these sectors to continue investing in expanding capacity. This global rush to invest in infrastructure is resulting in full order books (and first-rate earnings visibility) for a range of companies, from Korean shipbuilders to American energy services companies. For these, short-term problems in parts of the American housing market and in inter-bank overnight lending markets are almost an irrelevance.
So we remain gently bullish. Of course, parts of the financial sector have suffered in the subprime fallout. But the sell-off has been so severe as to discount a bleak outlook for the global economy. Analysis by a Swiss investment bank suggests that defaults on the worst tranche of subprime lending (from late 2006) are likely to reach 15%, meaning total losses of between $100 billion and $150 billion (£50 billion-£75 billion). This is just 2% of the global banking sector’s market capitalisation. So for any long-term investor the crisis will surely have created an attractive entry point in many financial stocks.
Finally, one feature of the grab for cash has been that the stocks that performed most strongly earlier in the year were those where cash-strapped investors saw the most profits waiting to be taken. But those stocks were performing well for good reasons. Fundamentally, nothing has changed – these stocks, like many American companies, remain in rude health. We think the patient will make a complete recovery.