July Investment Review
20 July 2011
By Richard Potts, Chief Executive
Economic and Market Background
The following chart is one I have featured before when the economic cycle was in its early stages of recovery. Then it had turned up and, as the last two years have demonstrated, it successfully foretold of a period of economic growth. Now it has turned down. We have clearly seen a succession of disappointing economic numbers and so the chart is not saying anything we are not aware of. However, the question is whether the decline is mid-cycle correction as we saw last year (for those with very good eye sight it is just possible to see this indicator drop slightly last year at this time) induced by high levels of inflation impacting real disposable income and the impact of the Japanese earthquake or something more sinister.
Source: Merrill Lynch
Only time will tell but any chance of higher interest rates in the US and UK has been pushed back into next year.
On balance we continue to think that the slowdown is unlikely to translate into a more profound contraction although there are two major risks (Greece and fiscal tightening) that could easily result in this. Our cautious optimism is based on three reasons. First, the Japanese earthquake has had a significant impact on industrial output throughout the World, not just Japan. Car manufacturing has been badly affected but there are signs, such as the production schedules for US manufacturers, that this has reversed and will be a positive contribution in the future. The rapid rise in oil prices from the beginning of the year until the end of May (25% rise) had a significant impact on disposable incomes thereby denting consumer
spending by a similar amount. Thirdly, the slowdown in economic growth in developing economies has reduced global aggregate demand but the policies in these countries to contain inflation are unlikely to reduce growth much further.
Politicians in Europe are wrestling with the Greek debt problems and currently failing so miserably that the IMF was moved to publicly rebuke them for their failure to find a solution. The longer the situation is allowed to persist for the worse it becomes, at the moment markets are generally giving them the benefit of the doubt that a solution will be found. There should be little doubt of the consequences to act to resolve the problem (default of some sort looks almost inevitable) in an orderly manner at a time of everyone’s choosing rather than be hostage to debt maturity schedules. In a similar manner the need to cut deficits in Europe and the
US is clear. Why it needs to be done in a precipitous manner is less clear. The swing from fiscal irresponsibility to fiscal conservatism may suit the electoral calendar but they are clearly not in the interests of the economy or its people. A balance needs to be struck between cutting spending but doing it in a way that doesn’t reduce aggregate demand too quickly.
Trends within the market are painting a mixed picture for most equity and currency markets; fixed income markets are almost all universally bullish. Equity markets are stuck with a declining intermediate term trend but a positive, albeit only just, primary trend. Major indices such as the All Share and the S&P 500 appear to be stuck in sideways trading ranges which will break at some stage, the question is when and in which direction.
Asset Allocation
Cash levels have continued to rise throughout the month. Had the support levels broken then we would have had to increase this further as well as making an asset allocation switch. With the primary trend now being challenged we may very well have to make this move to raise more cash. However, as will be discussed in more detail below the market action is not indicating that investors have completely given up on risk assets. As we have mentioned in our weekly analysis the copper price has started to rise again as has scrap steel. Within the equity market we are seeing
buy signals being registered in certain metals stocks and other industrial cyclical sectors continue to gain in relative strength. This action is suggestive of a mid-cycle slowdown rather than the precursor to another recession.
Equity Strategy
Sector rotation has been the theme for this year and there appears to be no end in sight to this. Over the last month we have seen some of the defensive sectors such as food manufacturing and pharmaceuticals begin to break down having posted strong relative returns since the beginning of the year. The mining sector, which has been volatile but in a generally downward direction since the beginning of the year, has started to show some positive signs with the price breaking up above key levels. Similarly, property, forest product and software companies have started to show positive momentum. What happens in Greece is going to dominate market events over the summer. However, taking a position on the potential outcomes of this is very difficult if not foolhardy. At best, strategy should be relatively neutral at the moment until we have greater clarity as to the way forward in Greece and the wider Euro area. If the problems are resolved in a decisive manner then the markets are likely to rally strongly. If however, there is no decisive action or Greece is allowed to default then there could be a significant sell off.
Disclaimer
The information in this document is for private circulation and is believed to be correct but cannot be guaranteed. Opinions, interpretations and conclusions represent our judgement as of this date and are subject to change. Past performance is not a guide to future performance and might not be repeated. The value of shares, and the income derived from them, may fall as well as rise. The information contained in this publication does not constitute a personal recommendation and the investment or investment services referred to may not be suitable for all investors; therefore, we strongly recommend you consult your Professional Adviser before taking any action. All references to taxation are based on current levels and practices, which may be subject to change. The value of any tax benefits will be dependent on the individual.
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