Principal Investment Management

Finding shelter from the storm - 11 August 2011

11/08/11

Executive summary

Volatile markets make us all edgy. But in the present feverish atmosphere it is important to remain cool-headed. Whilst recent economic news means that risks to global growth have undoubtedly risen, we should calmly focus on a balanced view of valuations. So, after a headlong flight to the safety of gold and government bonds in the US, Germany and the UK, we view these assets as fully valued. Meanwhile, we are looking to take opportunities afforded by the steep, often indiscriminate, falls seen in some high quality investments to add selectively to them where appropriate.

Wall Street has been hit by its own version of the riots that have coursed through the UK high street. We will be keeping calm , trying to pick through the debris looking for bargains in the turmoil.

Despite an agreement to raise the US deficit ceiling, markets have fallen sharply, reflecting concerns over three issues: continuing problems in the Eurozone relating to sovereign debt; the downgrading of US debt by Standard & Poor's (S&P); and fears of a global slowdown (and recession in some countries - notably the USA). Although markets have managed to rally since Tuesday morning in the face of initiatives from the central banks, the underlying issues remain.

We believe:

• the Euro project will not be abandoned at this stage, and politicians will do a lot more to promote stability in those markets;
• the US downgrade of debt, whilst regrettable, has a positive long term benefit in that it must surely focus the collective minds of lawmakers on the coming negotiations;
• slower growth is inevitable, but we hope a recession can be avoided.

In the event that we see continued weakness in the economy we feel it likely that the US authorities will be provoked into a further round of Quantitative Easing.

The markets remain volatile, and are reacting to almost daily emergency meetings. A good illustration of the current volatility was seen in the most recent European Central Bank (ECB) meeting over the weekend which saw a move to buy the bonds of Italy and Spain. This duly caused a sharp fall in Italian and Spanish yields and led to a rally in equity markets - until the US market opened, and the focus switched again to the US fiscal position.

Below we briefly explore the macro-economic outlook and review market levels.

Macro

We believe that uncertainties over debt levels are likely to persist over the longer term and the solvency and sustainability of the highly indebted nations will continue to be an issue for several years. Short-term solutions are merely "kicking the can down the road", with substantive improvements only to come over the coming years.

Economic growth is slowing, in some cases quite rapidly, as suggested by many of the Leading Economic Indicators. Growth is 'the' issue - without it the fiscal arithmetic of government budgets will be very difficult to sustain. However, there are glimmers of better news - US jobs data, UK Services Purchasing Managers Index, Japanese industrial production, German industrial confidence still high, falling oil prices a boost to the consumer, and interest rate rises now off the agenda.

Political desire to support the euro is very strong indeed and we think that the authorities have plenty of ammunition left to them: reversing the recent ECB rate rise; Eurozone Quantitative Easing; fiscal integration; limitless liquidity provision to the banking system; and fuller use of existing emergency infrastructure such as the (European Financial Stability Facility and the Securities Markets Programme).

The US Credit Rating downgrade is worrying, but:

1. was not unexpected from S&P;
2. is likely to have limited immediate repercussions (we note that Japan's bond market continued to rally in the face of a similar downgrade);
3. a budget impasse has occurred 18 times since WWII in the US;
4. it has begun to engender the necessary debate about rebalancing the budget in the US.

The emerging world is also very important for global growth. We expect China to continue to grow at around 7-8%; and The Emerging Markets (EM) economies' interest rate cycle is maturing, although we do think that in the short-term interest rates are likely to rise further.

Markets

The flight to 'safety' in recent days has taken Gilt yields, and yields on other bonds where covenant risk is deemed not to exist, down to levels at which we think that the potential for further capital appreciation is negligible in anything other than a full-blown recession.

Equity market falls have left many shares more attractively valued in anything like a soundly functioning economic environment. Of course, forecast valuations are based on assumptions made before the current crisis and require a critical eye on a stock by stock basis. However, we think it is an important difference with prior crises that corporate balance sheets are in very good health - both in the US and UK. Many stocks with seemingly secure dividends offer attractive yields too.

Ultra low interest rates, low nominal growth rates and strong corporate balance sheets are normally a good environment for merger and acquisition activity, higher dividends and buybacks. Therefore, although we acknowledge the risks have gone up, we remain cautiously optimistic on 'risk' assets over the medium to longer term: while we feel that the so called 'safe haven' of government bonds presents little value. So we are therefore gently reducing our fixed interest exposure and adding to strongly capitalised equities. We are of course very mindful that event risk is unusually high and will do this gently and progressively as further opportunities arise.